The Fed's Negative Message for the Markets

The stock market remains at risk for further declines.  Last week's market's plunge was likely exacerbated by a disconnect between Fed Chair Powell's hawkish anti-inflation message and the more measured forecasts contained in the FOMC Central Tendencies.  Powell was firm in leaving open the possibility that the Central Tendencies understate the extent of Fed tightening ahead.  To be sure, an understatement probably becomes relevant as a risk for the December FOMC Meeting on.  This is because a 75 BP hike at the November FOMC Meeting, consistent with the Central Tendencies, is probably a given.  Whether the market gets some relief in October, ahead of the November Meeting, could depend on the September Employment and CPI Reports surprising on the weak side.

Fed Chair Powell's said the Fed will not stop tightening until there is significant evidence that inflation is moving down to the 2% target.  Although he thinks the moderate pace of further tightening contained in the Fed's Central Tendencies is a reasonable expectation, it does not stand in the way for the Fed to tighten more aggressively if needed.  Policy will "evolve" as data come in.  In other words, take the Central Tendencies for what they're worth -- just forecasts -- and don't rule out additional tightening to what is built into them.  The Fed is adamant to make sure inflation will no longer be a problem.

He says financial markets are an important channel through which monetary policy will work to slow the economy and thus lower inflation.  Stocks have to fall, yields rise and dollar strengthen.  With Powell's stern warning in mind, financial markets may overshoot -- moving more than what will be necessary to achieve the Fed's goal.  Markets don't know how much tightening of financial conditions is needed to lower inflation -- and evidence becomes available with a lag.  The restrictive market moves may not end until significant evidence of a weaker labor market and lower inflation shows up.  This evidence would put a lid on Fed tightening. 

The Fed's Central Tendency forecasts are not as dire for the markets as Powell's warnings.  Most FOMC participants expect the Fed funds rate to end the year in the 4.0-4.5% area, suggesting some downshifting over the next two FOMC Meetngs after the funds rate was hiked to 3.25% last week -- most likely in December as another 75 BP hike in November makes sense for reasons I discussed last week.  The rate is seen being hiked just another 50 BPs in 2023, peaking at 4.6%.  Last week's Treasury market sell-off brought yields closer in line with the Central Tendency forecasts.  So, the worst may be over for now, but a relaxation of the sell-off may not last for long.

To put the 4.6% funds rate end-point in perspective, it is on the low side compared to past peaks (5.3-19.9%) that were followed by recession.  But, there are several reasons why it may be as powerful as rate hikes prior to past recessions.  /1/ The 4-1/2 percentage point increase from the trough in March is on the high side of the range of rate increases seen prior to recent recessions and /2/ has happened faster than in the past.  For example, it rose about 4 percentage points to 5.3% prior to the Great Recession of 2008, but it happened over 2-1/2 years.  Generally, it is not clear whether the level of the funds rate or extent/speed of increase in the funds rate is more important regarding economic growth.  /3/ The increase in the funds rate is being accompanied by reductions in the Fed's balance sheet, which could exacerbate the tightening at the long end of the Treasury yield curve.  

The other Central Tendency forecasts are fairly benign from a market perspective.  The FOMC expects below-trend economic growth in 2022 and 2023 -- not recession.  The Unemployment Rate is expected to climb modestly, peaking at 4.5%, and inflation to slow sharply over the next two years.

Specifically, Powell said the Fed wants to see /1/ higher Unemployment, /2/ a drop in Job Openings and Quits, /3/ a slowdown in wage inflation, and /4/ a slowdown in price inflation.  Unemployment Insurance Claims are the highest frequency data to watch regarding the labor market.  The latest data run counter to what the Fed wants to see.  Both Initial and Continuing Claims remain in a downtrend that began in mid-August.  Unless they begin to move up sharply, they will argue for more rate hikes.

 

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.

 

The Last Large Fed Rate HIke?

The stock market looks like it could be looking past the likelihood of a 75 BP hike at the September 20-21 FOMC Meeting, expecting it to be followed by a downshift at the next meeting.  A downshift to 50 BPs after the September meeting is conceivable, as evidence of a slowing economy and continuing pass-through of lower energy prices builds.  But, it's not a foregone conclusion.  This week's US economic data, nevertheless, should encourage this expectation.  

A 75 BP hike at the September FOMC Meeting is still the best bet.  Fed Vice Chair Brainard laid out the reasoning in a speech last week.  She acknowledged the recent decline in commodity prices and the low July CPI.  But, she needs these favorable developments to be sustained to convince her that inflation is being brought under control.  She said, "While the moderation in monthly inflation is welcome, it will be necessary to see several months of low monthly inflation readings to be confident that inflation is moving back down to 2 percent....How long it takes to move inflation down to 2 percent will depend on a combination of continued easing in supply constraints, slower demand growth, and lower markups, against the backdrop of anchored expectations."  These will take time to achieve.  And, she warned that "if history is any guide, it is important to avoid the risk of pulling back too soon."  So, even if the Fed  downshifts after the upcoming meeting, further rate hikes would seem to be likely.

This week's US economic data are expected to be in line with Brainard's prescription for bringing down inflation.  Consensus looks for -0.1% m/m Total and +0.3% Core for the August CPI.  And, the risks are to the downside for both.  Consensus also expects 0.0% m/m for both Total and Ex Auto August Retail Sales.  The drop in gasoline prices is behind both low estimates.  Once again it will be more important to see the Ex Auto/Ex Gasoline Sales print to get a sense of consumer spending.  It has been trending +0.7% m/m over the past few months.  Two manufacturing surveys are expected to be soft this week.   The September Phil Fed Mfg Index is seen falling to 3.5 from 6.2, while the NY Empire State Mfg Index is seen remaining weak at -15.25 after -31.3 in July. 

Brainard commented on the dichotomy between the strong job growth and weak GDP growth.  (The Atlanta Fed model lowered its estimate of Q322 Real GDP Growth to 1.3%.)  She said,"Labor demand continues to exhibit considerable strength, which is hard to reconcile with the more downbeat tone of activity.  Year-to-date through August, payroll employment has increased by about 3-1/2 million jobs, a surprisingly strong increase given the decelerating spending and declining GDP over the first half of the year."  I continue to believe that the dichotomy can be explained as a difference between the level of and rate of change in demand.  Jobs have been catching up to a high level of demand, while demand is slowing.  The dichotomy may be changing.  The latest Claims data suggest that companies may be finally pulling back on hiring.  A further slowdown in Payroll growth can't be ruled out at this point.

August Employment Report Opens Up Potential For Fed Downshifting But Maybe Not

The stock market is likely to remain under pressure as seasonal selling dominates in this data-light week.   The August Employment Report raised the possibility of a downshift in Fed tightening at the September 20-21 FOMC Meeting.  And, the August CPI, due September 13, risks doing the same.  But, it is not clear whether one or two reports will convince the "data-dependent" Fed to pull back from the pace of rate hikes.  There are reasons why the Fed may continue with another 75 BP hike.  Conceivably, the Fed may risk "overshooting" to ensure a sustainably low-inflation economy, which is what an "optimal control" solution would suggest.  This risk could hit the headlines on Thursday, when Fed Chair Powell will likely repeat the Fed's hawkish message in a speech.

The August Employment Report shows some softening in labor market conditions that should be welcome news for the Fed.  Payrolls slowed and the Unemployment Rate rose.  The 0.2 percentage point increase in the Unemployment Rate to 3.7% resulted from an increase in the Labor Force Participation Rate, which means there is more room for the economy to grow.  And, wage inflation moderated, although it is too soon to say the moderation will continue.  The 0.3% m/m increase in Average Hourly Earnings, after +0.5% in July, could just reflect volatility.  

Nevertheless, the slowdown in AHE hints at the possibility that the Unemployment Rate may not have to move much higher to permit inflation to settle down to the Fed's 2% target.  A 0.3% m/m pace (3.6% annualized), is consistent with this target, taking account of the 1.0-2.0% trend in Productivity Growth.  As I discussed last week, there are fundamental reasons why wage inflation may moderate -- the end of the decline in Unemployment and the easing of inflation expectations.

What might keep the Fed aggressive is that the Employment Report shows a strong underlying economy.  The +315k m/m increase in Payrolls is solid, even though less than the huge +526lk July gain.  Although Total Hours Worked slipped in August, the July-August average is 2.7% (annualized) above the Q222 average.  This is close to the 3.0% pace in the prior quarter.  The Atlanta Fed's model raised its projection of Q322 Real GDP Growth to 2.7% before the release of the Employment Report.  

An "optimal control" approach to the issue of how much to tighten suggests maintaining the 75 BP pace of hikes in the face of these mixed data.  Optimal control is a way to maximize an "objective function" subject to constraints.  In this case, the objective function shows the goal of as low as possible unemployment and inflation over the next two years (the time-frame of the Fed's Central Tendency forecasts).  The constraints are the Fed's econometric model, which posits an inverse relationship between unemployment and inflation.  The typical "optimal control" solution of the Fed's model calls for a sharp recession initially.  This allows for faster growth and lower inflation afterwards (my dissertation).  In other words, the economy needs slack to be able to achieve strong growth without stoking inflation.  Currently, the Fed's warning of near-term pain to achieve longer-term growth and low inflation seems to fit this optimal control solution.  If so, the latter suggests that we need to see much more of an increase in the Unemployment Rate to satisfy the Fed -- and thus a continuation of 75 BP hikes.

The next important piece of data is the August CPI, due September 13.   The Total should be depressed by the drop in gasoline prices, while the Core could be held down by the pass-through of lower oil prices to a wide range of other prices as well as by slower wage inflation.