ECONOMIC UPDATE
- Fed Chair Powell delivered another hawkish speech in Jackson Hole, implying a “higher for longer” mantra even as efforts to rein in inflation come with economic pain
- August was another painful month in a historically bad year for fixed income investors, and recent labor market and inflation data suggest the Fed won’t let up anytime soon
- Residential rent prices have surged over the last year, and the lag effect could apply upward pressure on the housing inflation metric of CPI for months to come
Higher for longer. That is the message from Fed leaders of late regarding the fed funds rate, combating market speculation of a Fed pivot at some point in 2023. The bond market has been swifter to accept this guidance from policymakers, with front-end Treasury yields repricing approximately 50 basis points (bps) higher in August leading up to Jerome Powell’s August 26 Jackson Hole speech. However, there had been a large pocket of equity bulls still holding out hope that Fed leaders’ inner-dove would emerge, but the combination of renewed hawkishness from Powell in Jackson Hole and more hot data on inflation and the labor market has effectively poured cold water on hopes that the Fed is contemplating a pause or 2023 rate cuts at this point.
Prior to Jackson Hole, Powell had acknowledged that a slowdown in the Fed’s tightening effort may be appropriate “at some point,” and even though he offered no timeframe for the vague observation, it further emboldened the “Fed pivot” camp. With this in mind, Powell delivered a much more concise 10-minute speech, the shortest by a Fed chair at the Jackson Hole conference since 2010, with the likely goal of leaving no room for obscure comments to be misconstrued as dovish.
Fed leaders have also made it clearer in recent weeks that price stability is the priority at this point and that a soft landing for the economy is a secondary and unlikely objective. To achieve the goal of price stability, Powell suggested it will require a “sustained period of below-trend growth” via “softening of labor market conditions” that will “bring some pain to households and businesses.” In other words, the decision-making framework has become much simpler for Fed policymakers with a dual mandate of price stability and full employment. With inflation rates significantly above target and unemployment near 50-year lows, they must continue tightening financial conditions until these factors become more balanced, and the labor market, and economy as a whole, cools off
To that end, the data of late have shown little signs of the recession narrative that emerged in mid-June, at least not yet. In the labor market, job growth remains strong and unemployment low. One metric that has been a clear area of focus for Fed Chair Powell is the number of job openings relative to the total number of unemployed persons. After rising to a 2:1 ratio in March (see Exhibit 1), it appeared to be moving in the right direction in the months that followed, albeit still well above historical norms. However, the ratio unexpectedly rose back near the March peak in July, with more than 11.2 million openings.
The July CPI report showed signs of improvement, at least superficially, but the underlying details were less constructive. The downside surprise in headline CPI was attributable to the decline in gas prices, and the lower-than-expected increase in the core measure was driven by declines in more volatile categories, while stickier categories continued to show upward price pressures. One category of particular importance as it relates to the core CPI tabulation is housing/shelter costs, which account for roughly 1/3rd of the headline rate and 40% of the core calculation. Most of the shelter inflation measure is captured with what is referred to as Owners’ Equivalent Rent (OER). The surge in home prices in 2020 and 2021 has been well documented, but rent prices have also risen sharply, as illustrated in Exhibit 2. It does appear that rent prices have peaked and are showing signs of easing. However, as Exhibit 3 illustrates, there is a lag in the time it takes for higher rent prices to flush through the monthly CPI data, so OER could be a contributor to above-trend core inflation for several months. This is unlikely lost on Fed leadership.
Looking Ahead
August was a painful reminder that financial markets are not out of the woods yet in what has been a historically bad year. As we have noted for several months now, volatility is likely to remain elevated until there is more clarity on inflation turning the corner and heading lower on a sustained basis, and it’s hard for that to happen when the labor market is still burning hot. A recent study by the New York Fed suggested that 40% of the inflation experienced in the prior two years was attributable to supply chain constraints, while the remaining 60% was attributable to stimulus-fueled demand. Their analysis made clear their opinion that these two are linked, and without supply-side constraints, inflation would have been 6% at the end of 2021, down from 9% but still well above target. Barring any new energy or other shock, the researchers opine that “ongoing easing of supply bottlenecks will cause a substantial drop in inflation in the near term.” If true, that could be the light at the end of the tunnel that fixed income and equity investors have been seeking, but then again, forecasters at the Fed haven’t had a good run recently. Short-term fixed income markets currently imply a terminal fed funds rate of approximately 4% realized in Q2 of next year, and Fed officials are trying to make clear of late that they intend to hold short-term rates at elevated levels for “some time.” Time will tell.
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