Tim Duy’s Fed Watch, 11/8/21

Published on November 8, 2021
SGH Insight
This feels to me like a potentially unstable situation. I continue to play with this scenario because it has a knife edge feel. With long yields held down, right now it looks like the Fed doesn’t have a lot of room to cool growth without inverting the yield curve, which suggests we don’t have a lot of space between fast growth and recession. This makes sense in a world where the Fed has flooded the economy with unneeded financial accommodation. The Fed maintained emergency levels of accommodation long after the emergency ended and continues to add accommodation albeit at a slower pace. What strikes me is that this acts with a lag. The maximum impact of the accommodation will be reached after asset purchases stop. That’s a long time to let this system run unimpeded.
I bring up this scenario because it raises the possibility that the Fed may need to focus on reducing the balance sheet before hiking rates. That’s not on the radar yet; we don’t have any visibility on the Fed’s balance sheet plans after asset purchases end. All the discussion is on rate hikes. As we move closer to March, balance sheet policy will need to come into focus. That’s something I will be looking for.
Market Validation
Policy Validation

Dow Jones 11/10/21

Federal Reserve Bank of St. Louis President James Bullard said
Tuesday that he was open to allowing the central bank's massive holdings of
cash and bonds to shrink at some point.

Mr. Bullard, who was speaking in a virtual appearance, was commenting on what
he would like to see happen once the U.S. central bank winds down, or tapers,
the process of expanding its holdings.

At last week's Federal Open Market Committee meeting, the Fed said it would
progressively slow its stimulus campaign of bond purchases and likely complete
that process by the middle of next year. That, in turn, opens the door to what
happens with the Fed's balance sheet: The central bank could keep it steady by
purchasing new bonds to replace maturing ones, or allow holdings to passively
shrink as securities run off.

"I think one thing we could consider going forward, which would lean a little
bit hawkish, would be to allow runoff of the balance sheet at the end of the
taper or shortly thereafter," Mr. Bullard said.

Monday Morning Notes, 11/8/21

If You Don’t Have Time This Morning

The Fed is attempting to lock down the near-term policy path by planning to end asset purchases ahead of the June 2022 FOMC meeting. It hopes to keep rate hike speculation focused on the second half of next year, putting a lot of pressure on the March SEP to preview the Fed’s intentions. The Fed has signaled it intends to assume any inflation through the middle of next year is transitory, suggesting only a substantial change in the inflation picture will prompt the Fed to accelerate the end of asset purchases.

Recent Data and Events

Job growth accelerated in October to 531k while August and September were revised up by a combined 235k:

The upward revisions indicate that the damage wrought by the Delta variant was less than believed. The private sector drove the gains with job growth of 604k compared to a public sector loss of 73k:

It appears that a range of 700-800k monthly private sector job growth was something of a speed limit for the U.S. economy. Labor force participation held steady:

The labor force has been barely budged the last four months; job growth is drawing on the ranks of the unemployed. This accounts for the sharp drop in the unemployment rate to 4.6%:

The level of unemployment is 1.7 million above pre-pandemic levels. That’s about 4 months of supply at the current three-month average job growth rate of 442k. Either labor supply finally perks up or job growth hits a wall at the end of the first quarter. Something to keep an eye on.

The prime-age employment to population ratio is on track to return to its pre-pandemic level in the third quarter of next year:

This is consistent with Federal Reserve Chair Jerome Powell’s observation that it is very possible to reach full employment in the latter half of 2022.

Wage growth slowed to a 4.3% annualized pace:

I suspect this slowdown is only temporary. With slower wage growth, aggregate weekly payrolls rose at “only” a 6.9% annualized pace compared to 19.6% in September. The average pace since March has been 11.5%, helping to propel aggregate weekly payrolls to within spitting distance of the pre-pandemic trend:

Nominal spending power will soon surpass pre-pandemic trend unless the labor market cools down sharply. As regular readers know, I am carefully watching this story. 11.5% nominal spending growth with 2% inflation means 9.5% real growth. Not happening.

Anecdotes of supply side shortages again dominated the ISM reports. The services sector rose to 69.8, a new record high. The details painted the picture of an economy on fire, well, everything except employment, which declined from 53.0 to 51.6. I have heard some commentary to the effect that the strong services report reveals the economy is in the process of rebalancing from goods to services. I am cautious about this interpretation. It comes back to nominal spending power; it’s growing fast enough that it can support more services spending without eroding goods spending:

Recall also that the Chicago Fed currently estimates retail sales excluding autos grew 2.3% in September:

And on the autos side, a few shipments of computer chips will send sales soaring. In short, I don’t think an increase in services spending requires a decrease in goods spending.

Both Powell and Governor Lael Brainard were spotted at the White House last Thursday. The wheels are turning quickly now, and we expect an announcement before Thanksgiving. The key report was this from Axios:

The White House is asking Democratic senators to meet with Federal Reserve chair Jerome Powell before Thanksgiving — leading some to believe President Biden will renominate him this month…

This sounds like the White House is preparing the Senate to expect Powell will be the nominee. The time is growing short to get a chair through the Senate Banking Committee ahead of the holidays to confirm early in January and Powell is the path of least resistance.

It’s finally infrastructure week. The House passed the infrastructure bill over the weekend. Build Back Better is up next.

Upcoming Data and Events

Inflation data will be the highlight of the week. We get PPI data Tuesday, but that doesn’t translate cleanly into consumer prices. On Wednesday, Wall Street anticipates an October rebound in CPI inflation with the core rate rising from 0.2% to 0.4%. The Fed, however, expects elevated inflation to persist into next year and has already stated its intention to accommodate that inflation. The JOLTS report will be released Friday. Wall Street expects a rebound in job openings; job postings on Indeed continue to climb through October:

This suggests that at a minimum we won’t see a substantial drop off in job openings anytime soon.

On Friday we also get the University of Michigan preliminary numbers for November. The focus will be on the inflation expectations component; if there is something that will force a hawkish Fed pivot, it is evidence that a self-reinforcing inflation/wages/expectations dynamic is evolving.

Fed speak starts ramping back up this week. We will hear from Presidents Evans (Chicago, Monday), Bullard (St. Louis, Tuesday), Daly (San Francisco, Tuesday), Kashkari (Minneapolis, Tuesday), and Williams (New York, Friday). From the Board we will hear from Clarida (Monday) and Powell (Tuesday).

Day Release Wall Street Previous
Tuesday PPI Final Demand, MoM, Oct. 0.6% 0.5%
Tuesday PPI ex. Food/Energy, MoM, Oct. 0.5% 0.2%
Wednesday CPI, MoM, Oct. 0.6% 0.4%
Wednesday CPI ex. Food/Energy, MoM, Oct. 0.4% 0.2%
Wednesday Initial Jobless Claims 265k 269k
Friday JOLTS Openings, Sep. 10.92m 10.43m
Friday UMich Sentiment, Nov. P 72.5 71.7
Friday UMich 5-10 Yr. Inflation Expectations 2.9%

Fed Speak and Discussion

Last week’s FOMC meeting and subsequent press conference helped reset baseline expectations. Going into the meeting, markets had shifted focus to concerns that the Fed would turn hawkish even more quickly than anticipated. While the Fed has drifted hawkish, pulling the taper forward to this month, it has not drifted so hawkish as to be prepared to pivot to rate hikes anytime soon. For now, the Fed has locked down a tapering schedule that they see likely to keep rate hikes out of the first half of next year. But they are no longer protesting expectations of a hike in the second half of the year, and in the extreme, if the Fed wanted to go straight from tapering to rate hikes, there is the June 14-15 meeting, which is technically in the first half.

The Fed is not ready to turn more hawkish right now for three basic reasons. First, it believes the transitory inflation story. Second, it thinks the economy is still far from full employment. Third, with as of September only half of FOMC participants expecting a rate hike in 2022, there is still plenty of room to pull forward participants’ expectations without interfering with the tapering schedule. Federal Reserve Chair Jerome Powell both at the press conference and ahead of the blackout period said it’s possible to reach full employment by the second half of 2022, opening that window for a potential rate hike if the data confirms. That’s the likely zone the Fed thinks it is playing with as far as the timing of the first rate hike is concerned.

Looking forward the objective will be to track how the Fed’s policy expectations unfold over the next several months. This is the rough descriptive guideline I am thinking about:

Of course, this is just illustrative as there would be no guarantees about exact dates. Two rate hikes could be July and December, for example. Still, using the September SEP as a guide, my starting place is on the dovish side of the spectrum, between no hikes and December, so I am just puling forward from December. We will see some upward drift in the dots in the December SEP, but I think the more significant movement won’t come until the March SEP. At that point, with the end of asset purchases in sight, the Fed is going to need to firm up its guidance for the second half of the year. That’s also the time when the Fed could pull a Bank of Canada pivot, cut off asset purchases in April and gear up for a May hike. That would be an extreme move, probably precipitated by an obvious shift in the wage/inflation/expectations dynamic that couldn’t be ignored. The way I see the data unfolding now relative to the Fed’s tolerance for inflation, my expectation is the Fed will need to raise rate expectations to the “hawkish” scenario with two rate hikes in 2022 by the March meeting with risks weighted toward the more hawkish side.

The steepening of the yield curve in the wake of last week’s FOMC meeting was short-lived. I had thought we could get a longer lasting near-term reversal of that move, but the bull flattening after the employment report ended that quickly. We may get some near-term upward pressure on long rates with Biden’s economic plans almost close to the finish line. Still, the situation highlights my previous comments about the fundamental weight sitting on long-term yields. There is a lot of money looking for a safe home while the Fed has pulled over $4 trillion of safe assets off the market since the pandemic began and will continue with additional purchases through next May. And even though the Fed will be ending asset purchases, Treasury will be issuing less, so the Fed stepping out of the market doesn’t fix the asset shortage.

Meanwhile, corporate financing costs are near zero or negative in real terms:

Low nominal interest rates plus higher inflation to pass through costs should be a strong positive for corporate finances, which should in turn be positive for equities. There is a reason that equities have broken out solidly to the upside now that it’s apparent that the Delta variant was at most a short-term drag on activity.

This feels to me like a potentially unstable situation. I continue to play with this scenario because it has a knife edge feel. With long yields held down, right now it looks like the Fed doesn’t have a lot of room to cool growth without inverting the yield curve, which suggests we don’t have a lot of space between fast growth and recession. This makes sense in a world where the Fed has flooded the economy with unneeded financial accommodation. The Fed maintained emergency levels of accommodation long after the emergency ended and continues to add accommodation albeit at a slower pace. What strikes me is that this acts with a lag. The maximum impact of the accommodation will be reached after asset purchases stop. That’s a long time to let this system run unimpeded.

I bring up this scenario because it raises the possibility that the Fed may need to focus on reducing the balance sheet before hiking rates. That’s not on the radar yet; we don’t have any visibility on the Fed’s balance sheet plans after asset purchases end. All the discussion is on rate hikes. As we move closer to March, balance sheet policy will need to come into focus. That’s something I will be looking for.

Bottom Line

The game now is watching the data to see how far the Fed feels it needs to pull forward rate hikes into 2022.

Good luck and stay safe this week!

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