Tim Duy’s Fed Watch, 5/2/22

Published on May 2, 2022
SGH Insight
Higher mortgage rates should bite harder into the housing market in April (note that mortgage purchase applications have now fallen to pre-pandemic levels), but this is a very unhealthy market characterized by elevated builder costs, strong demographic demand supported by rapid job and wage growth, low inventories, and an inflationary mindset among purchasers. Odd dynamics might evolve.

Market Validation
Rick Palacios Jr.
April homebuilder survey results are here. Top themes: 1) Demand is slowing, namely entry-level due to payment shock. 2) Investors are pulling back. 3) Ripple effect of rising rates starting to hit move-up market.

If You Don’t Have Time This Morning

It was great to meet with many of you last week in New York. Looking forward to my next trip.

Seeking to get policy rates to neutral as soon as possible without breaking markets and the economy to cool inflationary pressures, the Fed will begin the first of a series of 50bp hikes this week. Powell will remain solidly focused on “restoring” price stability, a clear indication that he isn’t thinking of soon transitioning back to 25bp hikes. Most likely, we have four such hikes ahead of us at a minimum. Powell likely doesn’t want to feed into any hopes of a 75bp hike, but if he lends any credence to that story, even accidently, market participants will rush to price in 75bp for the June meeting.

Recent Data and Events

Headline GDP growth turned negative in the first quarter, yet underlying details were surprisingly strong. The combination of falling exports and rising imports, the latter driven by strong private demand, dragged down growth by a whopping 3.20 percentage points while inventories cut growth by another 0.84 percentage points. Fixed investment contributed a solid 1.27 percentage points but even more surprising to me was that consumer spending accelerated despite March’s inflation shock. Underneath the surface, final sales to private domestic purchasers grew at a 3.7% rate – the fastest pace since the second quarter of last year. Needless to say, it is best to dismiss commentary that views the headline number as recessionary.

March consumer spending eked out a small 0.2% gain in real terms, a remarkable outcome given the high level of headline inflation on the back of skyrocketing energy prices. Nominal spending continues to grow at a rapid pace well above the pre-pandemic trend, while in real terms spending tracks just below trend:

Of course, a faster pace of inflation accounts for the difference. Households have been able to absorb higher prices in part due to still strong income growth, supported by rapid gains in jobs and wages:

Still, wage and salary growth has slowed a notch and I had worried the real data would struggle more. That said, I also posited that households could absorb the inflation via other sources of spending power, drawing down on net wealth by using savings or credit. That is exactly what happened with the savings rate declining to a fresh post-pandemic low of 6.2%, compared to 7.8% in January 2020, the eve of the pandemic. Even so, households have barely touched the excess savings accumulated during the recession:

With this much excess savings, there is no reason that the savings rate can’t drop to the housing bubble lows of 2.1% (July 2005) or even lower if households desire to maintain spending in the face of ongoing high inflation. Headline inflation will fall sharply in April, which will support a rebound in real spending assuming, as is likely, that income growth remains strong.

Notice that in nominal terms, spending on both goods and services continues to grow. In other words, households have not shifted their nominal spending in favor of services yet:

In real terms, however, high inflation has taken a bite out of goods spending:

There are some shifting patterns of real purchases underneath the surface but be wary of trying to tell macro stories from micro dynamics. On a final note, core inflation decelerated as known from the CPI data:

Services inflation, however, accelerated:

The Fed doesn’t just need goods inflation to moderate, it needs services inflation to not accelerate as households push more spending onto the services sector. We will see what happens, but so far, the Fed is on the wrong side of that bet.

New single-family homes sold in March fell but remain on trend:

Amazingly, prices continued to rise despite rising interest rates:

Higher mortgage rates should bite harder into the housing market in April (note that mortgage purchase applications have now fallen to pre-pandemic levels), but this is a very unhealthy market characterized by elevated builder costs, strong demographic demand supported by rapid job and wage growth, low inventories, and an inflationary mindset among purchasers. Odd dynamics might evolve.

In other big news for the week, the employment cost index came in hot, with wage growth for private sector workers, excluding incentive-based workers, rising to a fresh high:

Federal Reserve Chair Jerome Powell has drawn attention to the rapidly rising ECI number in the past, and it certainly confirms his claim that the labor market is operating at an unhealthy level. Prior to the pandemic, ECI growth of around 3% was consistent with inflation just under 2%, say 1.8%. This number was 5.7% (annualized) in the first quarter which, assuming a linear relationship, suggests underlying inflation pressure close to 4.5%, or more than double the Fed’s target. No wonder then that market participants see this number and think “75bp.” More on that later.

Upcoming Data and Events

Jobs data will be the highlight for the week. We get JOLTS job openings for March on Tuesday. Powell has drawn attention to this number, pinning his hopes on the ability of the Fed to guide openings lower without a recession. I think openings have peaked for this cycle, but it will take a large decline from this point to bring stability to the labor market. On Wednesday ADP releases its estimate of private sector employment which may help foreshadow another solid jobs gain for April. The main event will be Friday’s employment report. Wall Street anticipates an almost Goldilocks report for the Fed, at least at this point in the cycle, with a modest deceleration in jobs growth but a stable unemployment rate and wage growth that is elevated but not so much that the Fed can’t see a path to 2% inflation. An unexpected decline in unemployment will fuel fears that the Fed isn’t getting to 2% inflation without a recession. In addition, we get the usual manufacturing and service sector updates and the weekly mortgage applications report.

The May FOMC meeting concludes Wednesday; Powell’s press conference will follow. See the discussion of the Fed below. Other speakers this week, all Friday, include Bostic (Atlanta) and Daly (San Francisco), both giving commencement speeches, Williams (New York) with opening reports for an environmental economics event, and Bullard (St. Louis) and Governor Waller speaking at the Hoover Institute. These last two, the more hawkish FOMC members, are in a venue more conducive to policy guidance compared to the other speakers on Friday.

DayReleaseWall StreetPrevious
MondayS&P Global US Manufacturing PMI, Apr. F59.759.7
MondayISM Manufacturing, Apr.57.857.1
TuesdayJOLTS Job Openings, Mar.11.3m11.3m
WednesdayMBA Mortgage Applications, Apr. 29-8.3%
WednesdayADP Employment, Apr.388k455k
ThursdayS&P Global US Services PMI, Apr. F54.754.7
ThursdayISM Services, Apr.58.758.3
ThursdayInitial Unemployment Claims183k180k
FridayUnemployment Rate, Apr.3.6%3.6%
FridayNonfarm Payrolls, Apr.390k431k
FridayAverage Hourly Earnings, MoM, Apr.0.4%0.4%

Fed Speak and Discussion

The pace of rate hikes will step up to 50bp at this week’s FOMC meeting. The Fed will hike policy rates by 50bp, will signal more rate hikes of that magnitude are coming, and will announce plans for the balance sheet along the path laid out in the minutes of the March FOMC meeting. These points have at this point been well-communicated in advance. I don’t think the Fed wants the basic policy outcomes of this FOMC meeting to be a surprise. Surprises are more likely to come during Powell’s press conference.

At the press conference, Powell will deliver yet another fundamentally hawkish performance. Powell will cite tighter financial conditions as an indication that the Fed’s signaling is already having the intended effect and he will remind us that conditions will tighten further with the beginning of QT. I think he will say that asset sales are a tool that could be used in the future but remind us that the plan is to use interest rates as the primary policy tool; QT runs in the background and the path of rates will be adjusted as needed given QT. He will reiterate his intention to “restore” price stability. He will lean into the ECI number and bemoan the state of the labor market as unhealthy. He will again repeat his expectation that the labor market can be brought to heel by reducing labor demand (falling job openings) and this can be accomplished without creating more unemployment. This will be part of the “soft landing” story, the expectation that the Fed does not need to create a recession to bring inflation back to target. He will express cautious optimism that the Fed can avoid a recession, but he won’t promise such an outcome. We are well past the point that a soft-landing can be guaranteed.

Powell will need to address the issue of a 75bp hike at the next meeting. Unfortunately, I think for Powell, markets participants have their teeth locked onto the 75bp bone thrown at them by St. Louis Federal Reserve President James Bullard and San Francisco Federal Reserve President Mary Daly. The combination of both an arch-hawk and an arch-dove mentioning the possibility of 75bp rate hikes has been simply irresistible, especially considering the Fed’s one-way forward guidance. Except for a little pushback on pricing from Vice Chair Lael Brainard, the Fed hasn’t put up any guardrails to deter market participants from continually ratcheting up rate hike expectations, and instead has seemingly validated almost all pricing. I sense the Fed is at risk of losing control over their narrative and this loss of control exacerbates the volatility we are seeing bonds.

The Fed’s overall strategy is somewhat risky given that markets are pricing in rate hikes far, far ahead of the data we would think needed to justify those hikes. Logically, there should be a limit to how much the Fed wants us to price in now, but we aren’t seeing those limits, so why not 75bp? Of course, for that matter why not just two 100bp rate hikes and get to neutral since the Fed is saying that is where we are going anyways? That’s the funny thing about the Fed right now – it wants to tell us where it is going, appreciates our work in pricing in that path, but then wants to drag its heels in actually getting there.

I think Powell will want to push back on 75bp. I think the data flow over the next few months clears the way for the Fed to continue hiking in 50bp increments until it gets to the neutral range of 2.25 – 2.5%. That takes four more meetings, and I think that is the point where the Fed can transition back to 25bp if it sees indications of easing inflation pressures. Remember, the Fed did not turn to 50bp rate hikes until it first accepted that it would hike rates 25bp at every 2022 meeting. Stepping up to 50bp was the natural next step at that point, so 75bp would be the next step only after pricing in 50bp at every meeting this year.

I think Powell will signal that if the Fed needs to move more aggressively this year than currently expected, it will prefer that markets price in more 50bp rate hikes before a 75bp rate hike. If the Fed thinks at that point it needs to push rates beyond neutral more quickly, it can continue with another two 50bp hikes to arrive at a total of 325bp of rate hikes for 2022 (plus QT!) which would be more tightening in a shorter period than the 300bp between February 1994 and February 1995. If Powell said something to this effect, he would in effect be pushing back on 75bp.

That said, the risk is that Powell lends some credence to the 75bp story. If Powell gives any glimmer of hope that 75bp is on the table, market participants will price in a 75bp hike for the next meeting and the Fed will either need to eat that or play clean up later in the week. Market participants are focused on this topic, and if Powell doesn’t maintain discipline here, it will be seen as just the latest escalation on the part of the Fed. And, realistically, if Powell gives a glimmer of hope, given the market set up, he must know what is going to happen and wants to see 75bp priced in. I have to imagine that some journalist will press Powell on this; they all know if you get Powell to say “seventy five,” you have your story.

Notice that above I outlined a path to 75bp at a subsequent meeting even if Powell pushes back on it at this meeting. You can tell a story that at the June meeting, the SEP dots reveal 50bp hikes for the rest of the year. Once at that point, if the nexus of inflation and wages and, especially, inflation expectations suggests that inflation continues to get away from the Fed, then I believe you can get to 75bp at the July or September meetings. This isn’t my base case (my base case is that inflation numbers decelerate enough to leave the Fed positioned such that the next transition is from 50bp to 25bp), but many clients want to know the path to 75bp, and I think that’s the path. Still, you must get the consensus among FOMC participants to support 75bp hikes, and a lot of FOMC members will see that as basically a guarantee of a recession. It will take some extreme inflation numbers to make them willing to travel that road. And don’t forget that they know QT is working in the background as well.

Watch for Powell to offer more conviction that the Fed will need to push rates further above neutral during this cycle. I detect an improvement in the Fed’s guidance on the dots since the March Summary of Economic Projections. Those dots were very hawkish relative to the comments of Fed speakers, particularly the presidents, ahead of the March meeting, leaving the speakers appear almost out of touch with how policy was evolving. Since then, speakers have been clearer that rates will be near neutral by the end of the year, which means that the 2022 dots have already moved higher and probably close to market pricing. That in turn will put upward pressure on the 2023 dots, especially given that unemployment will be falling further, and super-core inflation trends look sticky at a high level. Indeed, even previously dovish speakers like Chicago Federal Reserve President Charles Evans have acknowledged that rates will likely move above neutral. By extension, that means the Fed’s estimate of the terminal rate must be moving higher relative to its estimate of neutral, which raises the question of whether the Fed will cause a recession. I posited in last week’s Monday note that the Fed could reasonably claim that short-run neutral rates have risen relative to the 2.25-2.5% long-run range, and consequently rates will not be as restrictive as it might appear. I am watching for the Fed to use this communications strategy to reinforce the soft-landing story.

Bottom Line

The near-term path for the Fed is clear. It will accelerate the pace of rate hikes and signal it will do what it takes to restore price stability. Whether or not it holds to that promise later in the year and into next remains to be seen. It is easy to be hawkish when the labor market is this strong. But what if the labor market weakens measurably and trend inflation is closer to 4% than 2%? Not yet evident to me what the Fed does in such a scenario.

Good luck and stay safe this week!

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