Tim Duy’s Fed Watch, 5/10/22

Published on May 10, 2022
SGH Insight
A soft landing does not mean unemployment rates will remain at current levels. The Fed believes that with labor demand outstripping labor supply, the economy can be put on the path to price stability by bringing down the excess demand for labor. For example, this from New York Federal Reserve President John Williams:
Although we are facing highly unusual and challenging circumstances, I am confident we have the right tools to achieve our goals. In fact, we have an advantage over previous inflationary episodes: Our monetary policy tools are especially powerful in the very sectors where we see the greatest imbalances and signs of overheating—such as durable goods and housing. Higher interest rates will cool demand in these rate-sensitive sectors to levels better aligned with supply. This will also turn down the heat in the labor market, reducing the imbalance between job openings and available labor supply.
Still, Williams added in the Q&A:
“When I think of a soft landing, it’s really a matter of, yes we could see growth below trend for a while and we definitely could see unemployment moving up somewhat but not in a huge way…I think that’s the challenge,” Williams said.
Similarly, Mester said that unemployment may need to rise, and the economy may experience another “quarter or two” with negative growth. To me, this is the Fed setting the stage to redefine a “soft landing” as a mild recession. Arguably, the shift in the Beveridge curve suggests that the natural rate of unemployment has risen, so the Fed can’t regain a healthy labor market without unemployment rising and, historically, the Fed can’t engineer a rise in the unemployment rate without a recession. I think the Fed is coming to terms that a return to price stability will require some turbulence and likely a period of very low growth at best.
Market Validation
5/18/22

“This is a strong economy and we think it’s well positioned
to withstand less accommodative monetary policy, tighter
monetary policy,” Powell said. “There could be some pain
involved to restoring price stability, but we think we can
maintain a strong labor market.”
Fed officials say they can reduce demand for jobs without
raising unemployment by much from its current level of 3.6%.
Powell, confirmed by the Senate last week to a second four-
year term at the helm, said the labor market would still be
strong even if the jobless rate was “a few ticks” higher than
that.

Fed Themes

Fed speakers have been out in force today, and I see them coalescing around some central themes. This is my effort to pull together those themes into one place:

  1. The next two meetings will end with 50bp rate hikes. To be sure, Federal Reserve Chair Jerome Powell already made this clear in the press conference, so we shouldn’t be surprised to see others follow suit. The Fed is providing very clear near-term guidance, but the picture turns fuzzy after the July FOMC meeting.
  1. No one will rule out 75bp rate hikes later in the year. I think speakers are sensitive to the criticism that “Powell shouldn’t have taken 75bp off the table.” To counter this criticism, they have gone out of their way to keep potential 75bp hikes as an option, but with some substantial caveats. If the Fed can’t see evidence of easing inflation pressures, speakers expect that the Fed will need to continue with 50bp rate hikes and may need to step up to 75bp hikes. I think the key factor that would drive the bigger hike is inflation expectations; evidence that longer-run expectations have become unanchored would create a “break the glass” moment for the Fed. That said, I don’t think this should be the base case; currently, I am looking for the transition back to 25bp later this year.
  1. Restoring price stability is the central objective. The Fed’s mandates are not in conflict. Inflation is too high and the labor market overheating. The Fed is “laser-focused,” as Cleveland Federal Reserve President Lorretta Mester describes herself, on bringing inflation back down to target. This focus creates an important downside risk. Inflation is a lagging indicator, and the Fed will eventually need to adjust policy accordingly. If the Fed adjusts too late, it will overtighten and create a higher risk of recession, or a deeper recession than maybe the Fed already anticipates (see below).
  1. The Fed does not expect to reach price stability to this year. Mester made this clear in her interview. The Fed can’t hope to achieve price stability this year or even next unless it wants to create a substantial recession, and that is not the goal. The Fed only needs to see convincing evidence that it can reasonably expect inflation to return to target over the forecast horizon to justify a transition back to 25bp hikes. That’s what we should be watching for as today’s tighter financial conditions begin to weigh on activity. Atlanta Federal Reserve President Raphael Bostic has been attuned to this story, shifting in a dovish direction relative to where he was last year.
  1. A soft landing does not mean unemployment rates will remain at current levels. The Fed believes that with labor demand outstripping labor supply, the economy can be put on the path to price stability by bringing down the excess demand for labor. For example, this from New York Federal Reserve President John Williams:

Although we are facing highly unusual and challenging circumstances, I am confident we have the right tools to achieve our goals. In fact, we have an advantage over previous inflationary episodes: Our monetary policy tools are especially powerful in the very sectors where we see the greatest imbalances and signs of overheating—such as durable goods and housing. Higher interest rates will cool demand in these rate-sensitive sectors to levels better aligned with supply. This will also turn down the heat in the labor market, reducing the imbalance between job openings and available labor supply.

Still, Williams added in the Q&A:

“When I think of a soft landing, it’s really a matter of, yes we could see growth below trend for a while and we definitely could see unemployment moving up somewhat but not in a huge way…I think that’s the challenge,” Williams said.

Similarly, Mester said that unemployment may need to rise, and the economy may experience another “quarter or two” with negative growth. To me, this is the Fed setting the stage to redefine a “soft landing” as a mild recession. Arguably, the shift in the Beveridge curve suggests that the natural rate of unemployment has risen, so the Fed can’t regain a healthy labor market without unemployment rising and, historically, the Fed can’t engineer a rise in the unemployment rate without a recession. I think the Fed is coming to terms that a return to price stability will require some turbulence and likely a period of very low growth at best.

  1. The Fed is increasingly wary of predicting that rates will need to rise above neutral. I think the Fed increasingly believes policy will need to turn restrictive to restore price stability, but I sense speakers are hesitant to lean into this story as much as I had anticipated. Powell, for instance, last week put the top end of neutral at 3% rather than the central tendency of 2.25-2.5% but didn’t offer conviction that rates would need to be restrictive. Likewise, Mester said she suspects policy rates will need to move above neutral but offers no conviction on how high above neutral or even the level of neutral. Two things are going on here. First, the Fed genuinely doesn’t know the level of neutral and is wary of drawing too many lines in the sand. Speakers, including Powell, have been fairly clear the Fed will need to feel out the appropriate path for policy after it gets rates closer to an agreed upon range of neutral – “closer” meaning after the next two 50bp rate hikes. Second, I don’t think the Fed wants financial markets to get too far ahead of the Fed. Pricing in too much now risks creating destabilizing market turmoil.
  1. The Fed is not unhappy with the downtrend in asset prices. Tighter financial conditions are a feature, not a bug, of the Fed’s rate policy. Higher interest rates, lower equities, and a stronger dollar are all part of the process. What the Fed doesn’t want to do is break financial markets, which so far hasn’t happened. Mester said today that the “financial market plumbing is working.” They aren’t yet seeing the kind of financial market accident that requires policy to change course abruptly. I don’t think that they care about any crypto-specific accidents. I think it’s frankly better for the Fed if crypto markets collapse before they become any more integrated with the traditional financial markets.
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