Focus on the Fed

The stock market will likely continue to contend with the possibility of further aggressive Fed tightening past the September 20-21 FOMC Meeting, after the unexpectedly high August CPI dashed hopes for a downshift in tightening at subsequent meetings.  But, it is conceivable that last week's pullback may have largely built in another two 75 BP hikes.  The 4.0% 1-Year Treasury Bill yield suggests this is the case on the fixed-income side, as it reflects an additional 150 BPs in the funds rate. 

Fed Chair Powell, at his post-meeting news conference, may face questions on why the Fed will continue to tighten aggressively in the face of slowing growth.  He will likely focus on the tight labor market, seen in strong job growth, low unemployment low and a high level of job openings.

The seeming contradiction of slow growth and tight labor market can be explained.  Job growth is catching up to the high level of economic activity, while the rate of change in economic activity is slowing.  Fed staff recognizes the distinction, saying in the July FOMC Minutes that "the projected level of Real GDP remains above potential this year."  From the Fed's perspective, the important aspect of the current situation is the high level of activity, as seen in the very low Unemployment Rate.  The absence of slack puts upward pressure on wage inflation, which, in turn, feeds into higher price inflation.  To achieve more slack requires below-trend economic growth for awhile or, to achieve it quickly, a recession.

The FOMC Central Tendency Projections could show a recession this year.  The average rate of change in Real GDP over the first three quarters of 2022 is -0.6%, using the Atlanta Fed model's latest forecast of +0.4% Q322 Real GDP Growth (q/q, saar).  Real GDP Growth would have to exceed 1.8% in Q422 for the full year change to be positive (by less if Q322 GDP Growth is seen higher than the current Atlanta Fed model's forecast).

Powell will likely reiterate that policy is now data dependent.  So, there is still a possibility of a downshift ahead.  But, another 75 BP hike at the November 1-2 FOMC Meeting may be a good bet.  Note that two 75 BP hikes would put the funds rate at 3.75-4.0%, finally reaching a level that would probably be viewed as restrictive by Fed officials. Perhaps a downshift to 50 BPs would be more agreeable to officials then.

There are two important data points before the November FOMC Meeting -- the September Employment Report (October 7) and the September CPI (October 13).  /1/ Unemployment Insurance Claims data, as well as a number of manufacturing surveys, so far don't suggest a slowdown in September Payroll growth or an increase in the Unemployment Rate.  Nevertheless, Payrolls could slow sharply if they catch up to the sub-300k ADP estimates for July and August.  /2/ Even if the Core CPI slows from the high 0.6% m/m increase in August, it would not be enough to sway the Fed.  As Fed Vice Chair Brainard said, it would take several consecutive months of low CPI prints to persuade her that the trend in inflation is coming down.

Besides upcoming data, there could be a political aspect regarding Fed policy.  Typically, the Fed does not change policy just ahead of an election.  A downshift could be viewed as a change in policy.  So, sticking with a 75 BP hike at the November FOMC Meeting could be defended as being politically neutral, since this tightening pace had been in effect since July.