Monday Morning Notes, 5/9/22
If You Don’t Have Time This Morning
The Fed has largely decided the near-term policy path, and it expects to tighten rates 50bp at each of the next two meetings. There is less guidance beyond that point, although the Fed expects the next transition will be back to 25bp rate hikes; it does not anticipate the need for 75bp hikes. Financial conditions have tightened, and the data will adjust accordingly. The Fed won’t say financial conditions have tightened enough to restore price stability, but we should be watching for signs that the Fed will be able to see a path back to price stability by the final quarter of the year.
Recent Data and Events
The employment report for April was largely devoid of easy “hot takes.” Employment rose by 428k in April while February and March were revised down slightly by a combined 39k. While the underlying trend remains very healthy, there has been some slowing in the last two months:
Likewise, there is some indication that the labor market has passed the point of peak wage growth:
That said, I would caution against drawing this conclusion prematurely. The ECI and Atlanta Fed wage data do not suggest wage growth has yet rolled over. This may be a composition issue, or we may be in a period between the rapid wage growth in lower wage sectors and upcoming stronger growth in higher wage sectors. Likewise, aggregate weekly payrolls have also slowed and are off the peak reached in the winter:
This is an indicator I watch closely as it is the key factor underpinning household nominal spending capacity. While the April reading of 8.1% remains elevated compared to the pre-pandemic period, it is also consistent with declining inflationary pressures relative to the winter and supportive of the “peak inflation” hypothesis. We don’t need inflation to revert to 2% this year to pivot the Fed back to a slower pace of rate hikes; we only need inflation to be low enough that the Fed can see 2% within the forecast horizon. In another sign of possibly reduced pressure on the labor market, temporary employment has flattened out the last two months:
Of course, two months data don’t make a trend, but again we should be watching for indications that the Fed can pivot back to 25bp hikes. Stability in the unemployment rate would help with that as well, and unemployment did hold at 3.6% in April, but the household survey was odd. Unemployment fell slightly by 11k, while employment fell by 353k and the labor force fell by -363k, stabilizing the participation rate relative to recent improvements:
I suspect this is largely just noise in the report and that the unemployment rate will decline further if job growth remains near recent levels.
Productivity growth turned deeply negative in the first quarter:
This was the largest decline in productivity since the third quarter of 1947. In addition, unit labor costs rebounded:
To be sure, I wouldn’t read too much into this report. It’s noisy data and we already knew that productivity would be weak given the decline in headline GDP in the context of still strong job growth, and we already know that labor cost growth is elevated. Still, recent trends of persistently weak productivity and high labor cost growth suggest some firms have become overstaffed – think Amazon and tech companies. A shift back to more aggressive cost control would put some downward pressure on employment growth.
Finally, the Fed reported that consumer credit rose by $52 billion in March. I have already discussed this in the context of the March personal income and outlays report; households sustained spending despite the inflation surge by tapping savings or debt, thereby pushing down the savings rate. Note that consumers continued this pattern into April with regards to debt:
If the savings rate stays low, aggregate incomes continue to grow strongly (as suggested by the April employment report), and headline inflation moderates (as it did in April), then we will likely see a jump in real consumer spending in April.
Upcoming Data and Events
Slower data week ahead with CPI as the highlight. Wall Street expects that headline inflation slowed sharply but that core inflation ticked up back to 0.4% for the month, whereas the Cleveland Fed expects a core rate of 0.5%. Neither outcome is great for the Fed. The Fed needs a mix of 0.3% and 0.2% outcomes for core inflation to see the path back to the 2% target over time. Other data includes PPI and the preliminary University of Michigan sentiment results for May.
Plenty of Fed speak this week. We hear from a slew of regional presidents, including Williams (New York), Barkin (Richmond), Kashkari (Minneapolis) along with Governor Christopher Waller, Mester (Cleveland), and Bostic (Atlanta), all on Tuesday. Bostic, Kashkari, and Mester will all make repeat performances later in the week, and Daly (San Francisco) will speak on Thursday.
|Wednesday||MBA Mortgage Applications, May 6||—||2.5%|
|Wednesday||CPI, Apr., MoM||0.2%||1.2%|
|Wednesday||Core CPI, Apr., MoM||0.4%||0.3%|
|Thursday||Initial Jobless Claims||190k||200k|
|Thursday||PPI Final Demand, Apr., MoM||0.5%||1.4%|
|Thursday||PPI Final Demand Core, Apr., MoM||0.6%||1.0%|
|Thursday||Univ. Of Mich. Sentiment, May P||64.0||65.2|
|Thursday||Univ. Of Mich. 5-10Y Inflation Exp., May P||3.0%|
Fed Speak and Discussion
The Fed has already determined the near-term path of policy. To be sure, nothing is set in stone, and policy decisions are technically made on a meeting-by-meeting basis. Still, at last week’s FOMC press conference, Federal Reserve Chair Jerome Powell could not have made the policy path any clearer:
We are on a path to move our policy rate expeditiously to more normal levels. Assuming that economic and financial conditions evolve in line with expectations, there is a broad sense on the Committee that additional 50 basis point increases should be on the table at the next couple of meetings.
This was not unintentional; it was a very deliberate policy signal. Powell would not give this guidance unless he knew there existed an extremely high probability that the outcome of the next two meetings would be 50bp rate hikes at each. In effect, Powell defined “expeditiously” as a series of at least three 50bp hikes for a total of 175bp of tightening across the first four meetings of this cycle. The data flow likely has little impact on the near-term policy path. “Expeditiously” has been defined and returning to something closer to a neutral rate is the appropriate policy goal under the vast majority of economic outcomes likely over the next few months.
Larger hikes are simply not likely. We keep beating this drum, but the 75bp rate hike story will not die easily and received a renewed boost from last week’s reported sharp rise in unit labor costs. But Powell was clear on this issue:
So 75 basis point increase is not something the committee is actively considering.
The Fed has essentially determined the outcome of the next two meetings, barring something crazy. Yes, Richmond Federal Reserve President Thomas Barkin refused to rule out 75bp, but also said that the current pace is already accelerated. Via Bloomberg:
“I never rule anything out. So I think anything would be on the table,” Richmond Fed President Thomas Barkin told Market News International in a podcast published on Friday. “I’ll just say our pace is pretty accelerated right now, and so if you go to the pace that the chairman suggested, that’s a pretty accelerated pace.”
Technically, by this standard Barkin is not ruling out 100bp either, but that’s also unlikely. I think Fed presidents are maintaining discipline on the 75bp question with caveats about it not being a base case, but my sense is that enough market participants have been blindsided by the Fed’s continuing hawkish pivot over the past six months that they are having trouble accepting Fed officials’ word at face value. Even though the next two meetings are all-but-already determined, Barkin did provide a path to 75bp later in the year:
“As imperfect as inflation expectation assessments are, if you start convincing yourself that inflation expectations are starting to move, that’s to me the strongest case to try to move faster,” said Barkin, who does not vote on policy this year. “Demand is very strong and inflation is very high. Both are pointing in the direction that you can raise rates and you can raise rates relatively quickly.”
We wrote this last week, that rapidly rising inflation expectations could trigger a “break the glass” moment for the Fed. But this would be a potential story for the back half of the year, and we think only after the Fed had already accepted 50bp moves for all the meetings of this year, something that wouldn’t be obvious until September.
The Fed views forward guidance as a powerful tool that limits the need for big rate hikes. This isn’t 1994 when the Fed didn’t have forward guidance to help smooth the path of rate hikes and instead changed rates in more uneven fashion. After the 75bp hike in November 1994, for instance, the Fed skipped the December meeting before hiking again (50bp) in January 1995. Forward guidance allows policy change to be felt ahead of its actual implementation. Fed officials repeatedly argue that financial conditions have already tightened much more than the Fed Funds rate suggests; St. Louis Federal Reserve President James Bullard has recently argued that the two-year Treasury yield is a better indicator of policy, and that rate has soared to a level last seen in 2018. Under this thinking, the Fed has plenty of room still to tighten policy further by extending the expected number of 50bp rate hikes before resorting to 75bp rate hikes. And, realistically, if we are thinking that more than 325bp of tightening this year plus QT isn’t enough, it is indeed a “break the glass” moment.
The Fed’s ability to implement policy via forward guidance suggests that a future pivot from 50bp to 25bp is more likely than 50bp to 75bp. Powell let slip that this is the direction the Fed is thinking:
You know, I think we need to — we need to really see that our expectation is being fulfilled. Inflation, in fact, is under control, and starting to come down. But again, it’s not like we would stop. We would just go back to 25 basis point increases. It’ll be a judgment call when these meetings arrive. But my, again, our expectation is, if we see what we expect to see, then we would have 50 basis point increases on the table the next two meetings.
This suggests we need to focus on what triggers the Fed to transition back to 25bp. At that point, we will get a clearer picture on the terminal rate. Back to Powell:
So really the way, really what we’re doing is we are — we’re raising rates expeditiously to the — what we see as the broad range of plausible levels of neutral. But we know that there’s not a bright line drawn on the road that tells us when we get there. So we’re going to be looking at financial conditions, right. Our policy affects financial conditions and financial conditions affect the economy. So we’re going to be looking at the effect of our policy moves on financial conditions. Are they tightening appropriately? And then we’re going to be looking at the effects on the economy. And we’re going to be making a judgment about whether we’ve done enough to get us on a path to restore price stability. It’s that. So if that path happens to evolve levels that are higher than estimates of neutral, then we will not hesitate to go to those levels. We won’t. But again, it’s it there’s a there’s a sort of false precision in the discussion that we as policymakers don’t really feel. You know, you’re going to raise rates, and you’re going to be kind of inquiring how that is affecting the economy through financial conditions.
Powell cannot yet say “financial conditions have tightened enough for now,” but he knows financial conditions are tightening. Mortgage rates and other interest rates have risen substantially, the dollar is stronger, and equity prices are down. This will have an impact eventually although current momentum in the economy obscures that impact. The Fed knows this, and it will affect Fed thinking about policy later this year. The Fed does not want to create a recession and won’t push forward indefinitely at a 50bp-per-meeting-pace if it can see a path to 2% inflation over the forecast horizon without such hikes.
The goal is to tighten financial conditions to reduce the pressure on the economy, not break the economy or the markets. Powell will need to feel his way through this process. Things I am watching include the impact of higher rates on housing, firms seeking productivity improvements via cost controls on labor, layoffs in the wake of the collapse in technology stocks, and the impact of slower global growth (lost in this discussion is the fact that both Europe and China are struggling). This doesn’t mean looking for a recession. It means looking for the space that allows the Fed to ease back on the throttle. It’s about whether the transition back to 25bp happens at the September meeting or later.
Good luck and stay safe this week!