By: Ken Green, Christen Dusselier and Phil Kernen
Last January, we wrote an article about the declining value of the Fed’s communication strategies. We explained that with growing inflation and the start of rising rates the Fed was talking too much, leaving investors less clear about the future path of monetary policy, the exact opposite of the goal. Last week provided the latest example of bad messaging.
Fed Chairman Jerome Powell has spent the last six months giving speeches and answering press conference questions with a singular focus: regaining price stability is the priority of the Federal Reserve. Inflation was much too high, and getting back down to its 2% target was urgent. Doing so would require rebalancing demand with productive capacity, which means higher rates, unemployment and possible economic contraction.
His most direct message came at the Fed’s August conference in Jackson Hole, WY. Stock and bond prices had started appreciating under the outlook that Fed interest rate increases were nearer to the end than the beginning. Powell set out to reassert the inflation-fighting narrative, stating that ‘while higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain’. Investors got the message that the Fed had more rate rises in store, and prices retreated.
It happened again last week. In a speech at the Brookings Institution, Powell highlighted promising developments around inflation but maintained ‘we have a long way to go in restoring price stability’. In the next breath, he introduced the contradiction to which investors paid greater attention, saying that ‘it makes sense to moderate the pace of our rate increases which may come as soon as the December meeting’.
Investors took this to mean the Fed was just about finished lifting interest rates. Futures markets trading projected a 0.5% increase in the December meeting and a 0.25% increase in February. A final 0.25% bump in March would leave us with a terminal rate between 4.75% – 5.00% before falling again in 2023 when the recession everyone expects finally arrives. This outlook is reliant upon inflation declining by more than half from the current level of 6.0% to less than 3.0% by the end of 2023, the assumption of which ignores at least three problems.
Forecasting (in)accuracy – In his speech, Powell recognizes the inability of private and Fed forecasters to predict inflation accurately in 2022. Fed forecasters have consistently raised their inflation forecast as it became clear that inflation was far stickier than previously thought. We can blame the uniqueness of COVID, but if the models aren’t changing, how can we expect better output? At this point, expecting inflation to reach 2-3% by the end of 2023 is more hope than accurate forecasting.
Sticky housing inflation – One of the main positive developments cited by Powell relates to shelter inflation or housing costs. Housing costs continue to increase in official inflation statistics, but optimists focus on a sliver of good news that new lease inflation is declining. Unfortunately, leases turn over slowly, one of many factors driving housing inflation’s stickiness. It’s a data point that is too little and too soon to generate excitement. Housing inflation isn’t likely to peak before the middle of next year.
Rising labor costs – Powell finally addressed the labor market and its impact on the services component in inflation data, excluding housing, which constitutes more than half of core PCE, an inflation index favored by the Fed. Wages make up the highest cost of producing these services, and the demand for labor continues to exceed the supply of available workers. The supply-demand imbalance is translating to wage increases broadly that suggest a formidable force keeping inflation uncomfortably high. Average Hourly Wages growth calculated by the Bureau of Economic Analysis for November was 5.1%. The Federal Reserve Bank of Atlanta’s Wage Growth Tracker showed that as of October 2022, wage growth was 6.0%, 7.3% for job switchers, and 5.2% for job stayers.
Investors are getting ahead of themselves. Inflation isn’t likely to slow as quickly as is hoped. More likely is a higher interest rate forecast from the Fed at their meeting next week that will reset market expectations.