Full Steam Ahead for the Fed
As predicted with the Fed facing a deteriorating inflation outlook, the minutes of the June FOMC meeting took on a decidedly hawkish tone. Participants agreed that countering the upside risks to inflation required accepting the risk of slower economic growth. The minutes give no reason to think the Fed will soon take on a more dovish tone, at least not until policy rates are at least at, or more likely slight above, long run estimates of neutral. To be sure, these minutes are arguably a bit stale considering falling commodity prices in recent days. Still, the Fed has been very clear that it needs to see clear and convincing evidence that consumer inflation will revert to the 2% target, and data supporting that outcome won’t come soon, meaning the Fed will resist validating the recent turn in rates markets.
FOMC participants saw a still-tight labor market at the June meeting:
Participants noted that the demand for labor continued to outstrip available supply across many parts of the economy. They observed that various indicators pointed to a very tight labor market. These indicators included an unemployment rate near a 50-year low, job vacancies at historical highs, and elevated nominal wage growth. Additionally, most business contacts had continued to report persistent wage pressures as well as difficulties in hiring and retaining workers.
There was a glimmer of hope, however, that wage pressure may be moderating:
However, some contacts reported that, because of previous wage hikes, hiring and retention had improved and pressure for additional wage increases appeared to be receding.
Participants expected labor markets to remain tight in the near term but to eventually come into better balance over time as the impact of tighter monetary policy weighed on labor demand. They remained hopeful that this could occur without substantial job losses:
In light of the very high level of job vacancies, a number of participants judged that the expected moderation in labor demand relative to supply might primarily affect vacancies and have a less significant effect on the unemployment rate.
The inflation picture, however, was disconcerting:
Participants noted that inflation remained much too high and observed that it continued to run well above the Committee’s longer-run 2 percent objective, with total PCE prices having risen 6.3 percent over the 12 months ending in April. They also observed that the 12-month change in the CPI in May came in above expectations. Participants were concerned that the May CPI release indicated that inflation pressures had yet to show signs of abating, and a number of them saw it as solidifying the view that inflation would be more persistent than they had previously anticipated.
And there was growing concern that inflation expectations would become unanchored:
While measures of longer-term inflation expectations derived from surveys of households, professional forecasters, and market participants were generally judged to be broadly consistent with the Committee’s longer-run 2 percent inflation objective, many participants raised the concern that longer-run inflation expectations could be beginning to drift up to levels inconsistent with the 2 percent objective. These participants noted that, if inflation expectations were to become unanchored, it would be more costly to bring inflation back down to the Committee’s objective.
Tight labor markets and a deteriorating inflation outlook convinced the Fed it was time for a 75bp hike, and that hike would likely be followed by another large hike:
In discussing potential policy actions at upcoming meetings, participants continued to anticipate that ongoing increases in the target range for the federal funds rate would be appropriate to achieve the Committee’s objectives. In particular, participants judged that an increase of 50 or 75 basis points would likely be appropriate at the next meeting. Participants concurred that the economic outlook warranted moving to a restrictive stance of policy, and they recognized the possibility that an even more restrictive stance could be appropriate if elevated inflation pressures were to persist.
The Fed did not commit to a 75bp rate hike in July, but since this meeting speakers have shown widespread support for another 75bp move. Even though participants raised their rate forecasts at this meeting, they still see the risks as weighted toward having to pursue an “even more restrictive stance” if inflation pressures do not ease. Also note that FOMC participants are united in their hawkishness. There is no mention of a “few participants” with a differing view of the appropriate policy path. This won’t last forever, but for now there is very minimal debate about the appropriate policy path. There will be more debate later this year as growth eases and policy rates are at or above neutral.
Participants thought it important to show the Fed’s resolve to restore pricing stability:
Many participants judged that a significant risk now facing the Committee was that elevated inflation could become entrenched if the public began to question the resolve of the Committee to adjust the stance of policy as warranted. On this matter, participants stressed that appropriate firming of monetary policy, together with clear and effective communications, would be essential in restoring price stability.
That commitment to show resolve, and the emphasis on clear and effective communication, is what keeps Fed speakers closely aligned with one another. There is institutional pressure not to break rank with the current hawkish consensus.
FOMC participants cited the inflationary impacts of commodity prices:
They noted that the surge in prices of oil and other commodities associated with Russia’s invasion of Ukraine was boosting gasoline and food prices and putting additional upward pressure on inflation.
And recall that Federal Reserve Chair Jerome Powell appeared to tie policy to headline inflation:
But all over the world, you’re seeing these effects. And so—and we’re seeing them here: gas prices at all-time highs, and things like that. That’s not something we can do something about. So that is really—and, by the way, headline inflation, headline inflation is important for expectations. People—the public’s expectations, why would they be distinguishing between core inflation and headline inflation? Core inflation is something we [on the Committee] think about because it is a better predictor of future inflation. But headline inflation is what people experience. They don’t know what core is. Why would they? They have no reason to. So that’s—expectations are very much at risk due to high headline inflation. So it’s become—the environment has become more difficult, clearly, in the last four or five months, and hence the need for the policy actions that we took today. Hence our resolution to get rates up and, ultimately, get them to where we think they need to be in coming months.
Since the June meeting, commodity prices have dropped sharply, raising the question of whether the Fed would remain committed to “expeditiously” raising rates to neutral by the end of the year. In particular, clients ask about the Fed’s willingness to carry through with the expected 75bp July hike. We think the Fed would find it difficult to deviate from the current plan. Besides the credibility problem of again flipping away from a strongly signaled move at the last minute, which might also induce more undesirable market volatility, the decline in commodity prices, and, related to that, market-based measures of inflation expectations, is likely the result of the Fed’s aggressive policy stance.
The Fed will feel it needs to follow through with its policy intentions if it wants markets to hold onto the new commodity pricing. Moreover, the commodity price declines may be short lived; one reason the Fed fell behind the curve last year was faith that commodity price declines then were sticky, which was not the case. Later this year, once policy rates are at or above neutral, and if commodity prices stay low and if core inflation starts easing meaningfully, then the Fed could begin debating moderating the pace of rate hikes back to 25bp. Still, I think the calendar doesn’t give room for this to happen until after the November meeting (our baseline is a 75-50-50-25 path for the rest of the year), if the Fed sticks with its guidance that it needs a “clear and convincing” inflation decline, something unlikely to occur without “series” of better inflation reports.
Separately, the JOLTS report revealed a smaller than expected decline in job openings in May. Openings and quits rates remain near cycle highs:
Openings are still high relative to the level of unemployment:
The best we can say is that the gap isn’t growing anymore, which speaks to some moderation in labor market tightness. Still, there is a long way to go before the labor market returns to balance according to this metric.
In other data news, the ISM services report for July came in above expectations, helping ease recession concerns. The new orders component fell somewhat from 57.6 to a still respectable 55.6, not the kind of decline one would expect if the economy was falling over a cliff. And while the prices paid component was down slightly, it remained very high at 80.1, suggesting that inflationary pressures are still very pervasive. It was interesting that despite anecdotal evidence of improving supply chains, the backlog of orders component jumped 8.5 points to 60.5. The employment component slid below 50 to 47.4, which I see as another indication that the labor market is moderating somewhat.
Bottom Line: The Fed is committed to not only restoring price stability, but also to projecting resolve to achieve that objective. That means in the near-term Fed speakers are likely to continue to follow through with the current expected policy path, which means a 75bp hike in July and another 50bp likely in September. Later this year, after the Fed is closer to neutral, and if the tone of the inflation data changes markedly, Fedspeak will become more diverse. For now, however, I expect the Fed will hesitate to start feeding into market speculation that it will soon take a more dovish interpretation of the appropriate monetary policy path.