Monday Morning Notes, 1/3/22
If You Don’t Have Time This Morning
The Fed and market participants continue to manage the timing of the first rate hike of this cycle in the context of the economic implications of the Omicron wave. With Omicron still primarily impacting the supply side of the economy, it shouldn’t derail a March hike although communicating that hike may be more challenging for the Fed.
Recent Data and Events
Nominal personal consumption expenditures gained a solid 0.6% in November although inflation eroded the entire gain in real terms. Whereas nominal spending is well above pre-pandemic trend, real spending is only back to trend:
Spending in nominal terms was driven by services:
There has yet to be the expected rebalancing of goods into services. Instead, spending capacity remains sufficiently robust such that both goods and services spending climbed higher in 2021. I remain skeptical that goods spending will revert to pre-pandemic trend. First, reversion is not necessary from the point of view of household budget constraints. If budgets are growing at a robust pace, there will remain capacity to support both goods and services spending such that services spending can grow without a reduction in goods spending. Spending patterns generally don’t change outside of a recession – in aggregate, households don’t suddenly decide to spend less if they don’t have to do so.
Second, households have other sources of spending capacity besides incomes. To be sure, I have focused heavily on the role of income growth in supporting spending and inflationary pressures. Interestingly, November saw some slowing in wage and salary growth:
The three-month trend remains elevated, to be sure. Still, I have argued that declining wage and salary growth would dampen inflationary pressures, so I am carefully watching this metric going forward. That said, it also bears mentioning that households can spend out of accumulated savings, by selling assets, or by expanding debt (notably via home equity). Indeed, household balance sheets are in excellent shape with financial obligations near record lows. There is room to support spending outside of income growth.
Third, demographics support housing, and housing supports spending. Housing starts rose in November:
Single family starts rebounded strongly and I expect they will continue to track along the pre-pandemic trend:
Those new homes need to be filled with durable goods. Beyond this, the Millennial generation aging into prime age working years – and along with that, peak salaries – will also support spending.
Inflationary pressures remained elevated in November with core-PCE price growth outpacing consensus expectations:
Inflation is not limited to a few items. Trimmed mean measures remain elevated, indicating broader price pressures:
Like last year, the Fed anticipates inflation will recede on the belief that the underlying dynamic remains anchored at 2%. That will of course be a key issue we will be watching as the year progress.
The Omicron wave has been leading to record numbers of Covid cases; I discuss the implications below.
Upcoming Data and Events
As always, we return from the holidays with a busy week of data. On tap this week are the Markit and ISM manufacturing and services sector surveys, the JOLTS report, and the ADP employment report. The highlight of the week is the December employment report. Wall Street expects a faster pace of job growth of 400k compared to 210k in December while the unemployment rate edges down further to 4.1%. We are looking for signs that allow the Fed to declare victory on the full employment trigger for rates hikes. Falling unemployment and accelerating wage growth would be helpful to tell that story, although as Powell has said this is a judgement call. The Fed can declare victory anytime it wants; at this point, it’s really about pulling together the consensus on that call.
Fed speak picks up slowly this week with comments by Bullard and Daly on the economy and monetary policy and Bostic on diversity issues. The Fed will release the minutes of the December meeting on Wednesday. I expect hawkish minutes. Two things we should be looking for are discussions about a March rate hike and balance sheet management after asset purchases conclude. Given our read of the policy and economic dynamics, and the Fed speak that followed the meeting, I anticipate that FOMC participants were circling around a March hike assuming Omicron does not disrupt the demand side of the economy, while they also recognize that shrinking the balance sheet will happen soon thereafter.
|Monday||Markit US Manufacturing PMI, Dec. F||57.8||57.8|
|Tuesday||ISM Manufacturing, Dec.||60.2||61.1|
|Tuesday||JOLTS Job Openings, Nov.||—||11033k|
|Wednesday||ADP Employment, Dec.||360k||534k|
|Wednesday||FOMC Meeting Minutes|
|Wednesday||Markit US Services PMI, Dec. F||57.5||57.5|
|Thursday||Initial Unemployment Claims||200k||198k|
|Friday||ISM Services, Dec.||67.1||69.1|
|Friday||Unemployment Rate, Dec.||4.1%||4.2%|
|Friday||Nonfarm Payrolls, Dec.||400k||210k|
|Friday||Average Hourly Earnings, MoM, Dec.||0.4%||0.3%|
Fed Speak and Discussion
The monetary policy picture did not change over the holidays. The New Year begins as the old one ended with the Fed positioned to begin hiking interest rates as early as March to manage last year’s unexpected surge of inflationary pressures. Below are the key monetary policy and economic themes we are working with at the beginning of the year.
Our baseline is and has been that the Fed begins rate hikes in March. Persistent inflationary pressures in the context of a tight labor market pushed the Fed to accelerate its tapering plans and open up room to pull its first rate hike forward. And the signaling since has if anything confirmed our expectations. Coming out of the December FOMC meeting, Federal Reserve Chair Jerome Powell clearly said the Fed did not need space between the end of asset purchases and the beginning of rate hikes, implicitly putting March on the table. Federal Reserve Governor Christopher Waller explicitly stated that March was a “very likely outcome.” Realistically, the signaling is clear; the only thing standing in the way of a rate hike in March is Omicron.
Our baseline is three rate hikes in 2022 plus quantitative tightening. The Fed penciled in three rate hikes for 2022 in the December SEP. While it seems like the Fed should expect four rate hikes if it anticipates a March hike, I think it expects that one quarter will be used for scaling back the size of the balance sheet. Such quantitative tightening (QT) would reduce the number of rate hikes needed to stem inflationary pressures. Waller suggested that QT should begin by this summer. That suggests a possible timeline of rate hikes in March, September, and December, with QT in June.
The risks tilt toward four hikes in 2022. The Fed’s December SEP projections of 2.7% core inflation and 3.5% unemployment at the end of 2022 appear to be an attempt to finally get ahead of the inflation story. If inflation does not decelerate as expected, the Fed will feel under pressure to add a fourth rate hike. Given the expectation that inflation remains elevated in the near term, the Fed would likely not recognize this until the middle of the year. To be sure, there is a risk that the Fed needs to pull back on its rate hike expectations, but I think that outcome would be more likely if demand were to suffer such that unemployment unexpectedly began to rise. That said, there doesn’t appear to be a big risk of that outcome now. Either way, the situation will evolve as the data rolls in over the course of the year.
Omicron will likely create a mess with the jobs data and in the process complicate the Fed’s ability to communicate its policy stance. Navigating Omicron is our biggest near-term challenge. We know the Fed views successive waves of Covid as having diminishing importance on the economy. We also know the Fed views successive waves as primarily supply-side shocks that depress output and put upward pressure on inflation.
Omicron is already creating severe staffing issues, yet this wave may not peak until late January. This has been on display during the holidays with thousands of canceled flights as airline workers are sidelined by illness. This may depress headline job growth in January and February if a surge of employees report out sick during the reference week. The Fed will work to communicate that it considers a wide range of employment indicators and will shift the focus to data like job openings, unemployment claims, and the unemployment rate as indicators of labor market tightness. Importantly, the Fed will be looking through to the other side of the Omicron wave. The economic and virus situations will likely need to go seriously sideways for the Fed to back down from a March hike. That said, bad news on the Omicron front (spiking cases, for example) will lead commentators to dismiss the chances of a rate hike or assume that the Fed will quickly back off after a hike or two. But the Fed has tended to be overly bearish heading into these Covid waves and consequently continued to ease into inflationary shocks. It is not likely to make that same mistake again.
Shutdowns remain very, very unlikely for the U.S. economy. Shutdowns would be an obviously more disruptive policy option that would call the Fed’s commitment to rate hikes into question, but they aren’t going to happen. Shutdowns are politically impossible in the U.S. This is especially the case during the Omicron wave where a combination of a more contagious, yet apparently less virulent, variant makes it virtually unstoppable but creates proportionately fewer public health consequences. Indeed, the administration’s commitment to the economy over the virus was revealed by the CDC’s reduction of the quarantine time from ten to five days for persons without symptoms. This strikes us as an acknowledgement that the administration cannot politically afford to derail the economy in a fruitless attempt to hold back Omicron by mass quarantining of asymptomatic cases.
This is not the case for the rest of the world, notably China. The combination of China’s zero-Covid strategy, perhaps a necessity required still by less-effective vaccines, and the contagiousness of the Omicron variant suggests a long period of frequent shutdowns lay ahead. Be on the lookout for a revival of the supply-chain narrative as Omicron makes its way through China.
We have a good idea where the Fed is headed – assuming the data holds as expected. The key issue will be the degree to which inflation moderates as the Fed anticipates. That probably has more to do with the number of rate hikes and amount of quantitative tightening than the timing of the initial rate hike. Given the persistence of elevated inflation and tight labor markets, the Fed is under pressure to begin rate hikes in March to manage the risk of falling further behind the curve.
Good luck and stay safe this week!