With the CME FedWatch Tool showing a likelihood of over 99% of a 25-bps hike in the first meeting of the year, the FOMC delivered exactly as expected, raising the federal funds rate to 4.50% – 4.75%.
This move places rates at their highest levels in over 15 years, following accelerated tightening including four consecutive hikes of 75 bps in 2022.
Governor Powell tried to maintain his hawkish tone, noting,
…we will need substantially more evidence to be confident that inflation is on a sustained downward path…very premature to declare victory or to think we really got this.
With inflation still near four-decade highs, the committee stated that tightening would be ongoing (unless disinflation became even sharper).
However, this message did not seem to find many takers.
On the contrary, markets ended higher yesterday, with the S&P gaining 1.05%.
Bond yields declined, the greenback fell to a low of 101, and gold breached $1,970 levels.
Although the Fed’s direction and magnitude were widely expected, the choice to downshift after a single half-percentage hike in December 2022 may be the first admission that the loosening of the monetary environment is near.
From ‘pace’ to ‘extent’
The authors of a research paper entitled ‘Have Lags in Monetary Policy Transmission Shortened?‘ published by the Federal Reserve Bank of Kansas City, wrote,
Our results suggest the peak deceleration in inflation may occur about one year after policy tightening.
The Fed having begun tightening during Q1 2022, may be wary that the combined effect of lags could well be upon us and may expose underlying fragilities in the economic system.
Unsurprisingly, in the FOMC statement, policymakers acknowledged the uncertainty around lags, noting,
In determining the extent of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy…
Rick Rule, a well-known commodities investor, and formerly the President and CEO of Sprott US Holdings, warned,
…it may be that we have not yet felt the hard punch of the interest rate rises.
Crucially, the Fed altered the use of the word ‘pace’ and replaced it with ‘extent’ in the above text, a clear sign that policy uncertainty has risen, and the current tightening cycle may have run its course.
In response to the Fed’s December meeting, Danielle DiMartino Booth, CEO & Chief Strategist for Quill Intelligence, shared similar concerns around the ‘compressed lag effect’, commentary on which can be found here.
Job market (ill-) health
Perceived tightness in the labour market has been central to the FOMC’s narrative around rate hikes.
Mike Shedlock, a well-known blogger, who goes by Mishtalk, has for several months made the case that employment is weaker than U3 unemployment and headline nonfarm payrolls would suggest.
Source: US FRED Database
But with the steep fall in the blue line, what gives?
For starters, labour participation rates have been on a downtrend since the GFC.
There has also been a mass exodus of workers since the onset of covid, while full-time roles plummeted by nearly half a million in the back half of 2022.
Part-time employees and gig workers, many of whom would prefer full-time work, surveys show, are the main ones propping up employment figures.
Some of these key factors were expanded upon in an earlier article on the state of the labour market for Invezz.
Barely two weeks ago, December data showed that 35,000 temporary workers were let go (an explainer is available in a piece on the Employment Cost Index from earlier in the week), marking the sharpest decline since early 2021.
Although job openings headed higher according to a report by the BLS published yesterday, layoffs were up as well, rising 15% YoY, particularly in sectors sensitive to interest rates.
Inflation uncontained?
Peter Schiff, Chief Economist & Global Strategist at Euro-Pacific Capital, believes that given the unprecedented stimulus post-2008 as well as fiscal injections amid the pandemic, rate hikes themselves have not been as effective as claimed.
For instance, credit card debt has risen to above $16 trillion in Q32022, while the savings rate has crashed to nearly an all-time low of 2.3%.
Manufacturing (discussed here) remains lacklustre, adding to the central bank’s list of woes.
Along with other factors such as the deep fall in retail sales, the prolonged inversion of the yield curve and rising recession risks, the Fed may be forced into cutting rates later in the year.
Given the weakness in these indicators, the overstated strength of the jobs market, and elevated auto, consumer and mortgage debt, the USA may be looking at a much deeper recession than anticipated.
If the FOMC were to pivot, Schiff expects,
Inflation is going to get much worse…. disinflation is transitory.
Drawing on an admittedly small sample size, the current round of disinflation has commenced extraordinarily quickly and perhaps unsustainably so.
In the seventies and eighties, US consumer price inflation breached 8% on two separate occasions. First, from 1973 to 1975, it stayed above 8% for 23 consecutive months. In the second case, between 1978 and 1982, this lasted a mammoth 41 consecutive months.
In comparison, during 2022, inflation dipped back below 8% within 7 months and has now declined to 6.5%.
Outlook
Given possibly weaker-than-acknowledged labour data, savings shortage and the optimistic response of financial markets in the aftermath of Powell’s speech, monetary authorities may have indeed ceased the tightening cycle.
If so, cuts would likely be unavoidable by Q2 or Q3, meaning that inflation could be reignited (perhaps ferociously).
To get a more comprehensive picture of the labour market position, investors will be closely watching tomorrow’s jobs report.
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