Fed Chairman Jerome Powell’s remarks to the Brookings Institution, Wednesday 30th November, addressed two key questions:
- What does the Fed expect inflation to do in the months ahead?
- How is Fed monetary policy likely to respond?
Where is inflation headed?
“Despite the tighter policy and slower growth over the past year, we have not seen clear progress on slowing inflation.”
Powell focuses on core PCE inflation — which excludes food and energy, over which the Fed has little control — as this gives a “more accurate indication of where overall inflation is headed”. Core PCE is divided into three categories: (a) Core Goods; (b) Housing Services; and (c) Non-Housing Services.
Core Goods inflation is falling as supply chain issues are resolved and energy prices decline.
Housing Services is rising but tends to lag actual rental increases by 6 to 9 months. Rents were growing at between 16% and 18% in mid-2021 when PCE housing services inflation was still below 4% which means that core PCE inflation in 2021 was understated by a sizable margin. Housing services inflation is expected to fall “sometime next year” as lower rental renewals begin to feed into the index.
Non-Housing Services — the largest of the three categories — “may be the most important category for understanding the future evolution of core inflation” and, by inference, the evolution of broad inflation.
This spending category covers a wide range of services from health care and education to haircuts and hospitality…..Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category.
In short, if you want to understand the future of inflation, look at the labor market.
Demand for labor far exceeds the supply, with job openings at 10.3 million in October far above unemployment at 6.1 million.
The primary causes of the current tight labor market are: (a) a large number of workers taking early retirement; and (b) a surge in deaths during the pandemic.
The Fed believes that there is still some way to go:
So far, we have seen only tentative signs of moderation of labor demand. With slower GDP growth this year, job gains have stepped down from more than 450,000 per month over the first seven months of the year to about 290,000 per month over the past three months. But this job growth remains far in excess of the pace needed to accommodate population growth over time — about 100,000 per month by many estimates…..
Wage growth, too, shows only tentative signs of returning to balance.
Today’s ADP data warns of a manufacturing and construction slow-down but growth in services employment and overall earnings:
Private businesses in the US created 127K jobs in November of 2022, the least since January of 2021, and well below market forecasts of 200K. The slowdown was led by the manufacturing sector (-100K jobs) and interest rate-sensitive sectors like construction (-2K), professional/business services (-77K); financial activities (-34K); and information (-25K). The goods sector shed 86K jobs. On the other hand, consumer-facing segments were bright spots. The services-providing sector created 213K jobs, led by leisure/hospitality (224K); trade/transportation/utilities (62K); education/health (55K). Meanwhile, annual pay was up 7.6%. “The data suggest that Fed tightening is having an impact on job creation and pay gains. In addition, companies are no longer in hyper-replacement mode. Fewer people are quitting and the post-pandemic recovery is stabilizing”, said Nela Richardson, chief economist, ADP. (Monex)
Fed monetary policy
Powell continues, hinting at a moderation in the rate of increases:
Monetary policy affects the economy and inflation with uncertain lags, and the full effects of our rapid tightening so far are yet to be felt. Thus, it makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down. The time for moderating the pace of rate increases may come as soon as the December meeting.
The Fed is deliberately feeding optimism on Wall Street, but we are unclear as to their motive. Possibly it is an attempt to manage long-term Treasury yields. Keeping LT yields low would most likely raise earnings multiples for stocks and lower mortgage rates for home buyers, slowing the decline in asset values.
More likely, as Wolf Richter points out, a buoyant stock market gives the Fed political cover for further rate hikes. Plunging asset prices would ramp up political pressure on the Fed to cut interest rates, whereas market gains take the heat off the Fed, giving them further leeway to hike interest rates.
Conclusion
Fed policy is likely to be determined by two factors:
- moderation of core PCE inflation to below the Fed’s 2% target; and
- a significant rise in unemployment and/or fall in job openings. Powell describes this as “restoration of balance between supply and demand in the labor market.”
They are likely to continue hiking rates, but at a slower pace of 50 basis points, at least for the next two meetings.
Thereafter, we expect them to raise rates at a slower rate or, alternatively, pause and wait for the impact of past hikes to feed through into the broader economy. It could take 6 to 9 months to see the full effect of past hikes.
Unless something drastic happens, the Fed is unlikely to cut rates. Powell concludes (emphasis added):
It is likely that restoring price stability will require holding policy at a restrictive level for some time. History cautions strongly against prematurely loosening policy. We will stay the course until the job is done.
P.S. The Dow rallied 700 points by the close, after Powell’s speech (WSJ). That increases the probability of at least one more 75 basis point hike at the next meeting.