The Fed Leans into The Recovery
The stage is set for an increasingly tense standoff between market participants and the Federal Reserve over the coming months. The minutes of the January FOMC meeting reinforce the messaging by Federal Reserve Chair Jerome Powell and his colleagues that the Fed, following its new policy strategy, has no intention to risk short circuiting the recovery by prematurely removing policy accommodation. The Fed is an immovable object while market participants are processing the possibility if not likelihood that the economy is an unstoppable force. Can the Fed really sit on its hands while the economy grows into a raging but inflation-free fire? The Fed is signaling that is exactly what it intends to do.
Although the minutes expressed optimism about the outlook, consider these mentions of the labor market:
“…participants noted that economic activity and employment were currently well below levels consistent with achieving maximum employment.”
“Most participants noted that the economic downturn had not fallen equally on all Americans and that those least able to shoulder the burden—in particular, lower-income and Black and Hispanic households—had been the hardest hit by the pandemic. Many participants stressed that sustained support from fiscal policy would help address the hardships faced by these groups and that monetary policy could also help by promoting the economy’s return to maximum employment and price stability.”
“…participants observed that the economy was far from achieving the Committee’s broad-based and inclusive goal of maximum employment and that even with a brisk pace of improvement in the labor market, achieving this goal would take some time.”
The message here is that the Fed believes the economy is far from achieving maximum employment, that achieving maximum employment is essential to helping alleviate inequality, and that the road to maximum employment is long. All of that points toward a Fed that is planning to just sit back and watch the economy pick up steam. I think this is a particularly important aspect of the conversation:
“While labor market conditions had improved significantly, on balance, since the spring, some participants noted that if the sizable number of workers who reported having left the labor force since the beginning of the pandemic were to be counted as unemployed, the unemployment rate would be substantially higher.”
Not just “some” participants think this. One in particular thinks this. Powell from his labor market speech:
“…the Bureau of Labor Statistics reports that many unemployed individuals have been misclassified as employed. Correcting this misclassification and counting those who have left the labor force since last February as unemployed would boost the unemployment rate to close to 10 percent in January.”
This suggests that a declining unemployment rate alone will not necessarily meet the definition of “sustained progress” towards the Fed’s goals. Powell in particular may be pushing his colleagues to think in terms of something like population to employment ratios. We should be keeping this in mind if the next Summary of Economic Projections reveals a more optimistic forecast for the unemployment rate. Also, in terms of the calendar, the conditions conducive to drawing people back into the labor force – widespread vaccinations and open schools – won’t come fully into play until this fall.
Meanwhile, the Fed’s main concern around inflation was that market participants would mistake short-term pops for a long-term sustainable increase:
“Many participants stressed the importance of distinguishing between such one-time changes in relative prices and changes in the underlying trend for inflation, noting that changes in relative prices could temporarily raise measured inflation but would be unlikely to have a lasting effect.”
“…participants emphasized that it was important to abstract from temporary factors affecting inflation—such as low past levels of prices dropping out of measures of annual price changes or relative price increases in some sectors brought about by supply constraints or disruptions—in judging whether inflation was on track to moderately exceed 2 percent for some time.”
The Fed anticipates some bigger year-over-year inflation numbers ahead, it anticipates the criticism it will receive as a result, and it expects to ignore that criticism when setting policy. The Fed is looking for sustainable inflation at or moderately above 2% to hike rates and level effects aren’t that.
While the Fed sinks in its heels on policy, the economy is poised to rocket forward this year. Covid-19 cases are collapsing as the winter wave passes while the pace of vaccinations continues to accelerate, a combination that, if it holds, makes a substantial reopening of the economy likely in the second half of the year if not sooner (whether they should or not, states will be under enormous pressure to reopen as cases fall). Consider also that even in January, during the worst of the winter wave, the will to spend was strong. Supported by the December fiscal stimulus, retail sales for January smashed through expectations with the core sales rising 6%:
At the same time, industrial production also beat expectations, rising 0.9:
Industrial production is only 1.8% lower than last January. To be sure, producer price inflation surprised on the upside but the Fed has already warned us to expect some erratic price data and not all producer price pressures are passed through to consumer prices anyways.
To me, the data indicates that the economy continues to prove more resilient than anticipated. That strong base serves as a launchpad for activity when the pandemic comes under greater control while the December fiscal stimulus and the expected upcoming stimulus only provide additional fuel to thrust activity higher. When I look at that and combine it with a Fed that is just sitting on its hands, I see a steeper yield curve. And of course, that is what is happening.
I don’t think the Fed is overly worried about the long end of the curve. It is more worried about expectations for the near-term path of policy. If the Fed starts to sense that market participants are getting ahead of its expected policy path, policy makers will ratchet up the rhetoric to lock down near term expectations. This creates conditions for a game of cat and mouse between market participants and the Fed.
A final but important note: None of this means the Fed can’t or won’t change its expected policy path under any circumstance. Policy is outcome dependent. What we know though is that the conditions that would drive a change in policy such as substantial improvements in the labor market are unlikely to occur in the next six months. Sustainable inflation is even farther away. This is the time that the pressure builds before the Fed shifts. When that shift occurs, it may happen abruptly despite Powell’s intention to give us warning. That to me though is a story for later this year, but I remain watchful nonetheless
Bottom Line: Don’t doubt the Fed. It intends to let the economy run hot and will not change course until it sees a clear path to achieving its mandates. This is a whole new ballgame in comparison to previous cycles. The Fed intends to lean into, not against, the cycle for as long as it takes.