We believe the Fed faced a tricky communication challenge. On one hand it wanted to acknowledge its progress on reducing inflation. On the other, the Fed needed to do its best to prevent markets from rallying too much, thus loosening financial conditions, which could potentially prolong this period of high inflation and require further hikes down the road.
The Fed is doing its best to keep market expectations in check
The Fed’s “dot plot”, released in December, implies there are still more small hikes to go, with rates staying elevated into year-end. However, market pricing reflects rate cuts later this year (Figure 1).
Figure 1: Markets are pricing in a pause, meaning easier financial conditions than the Fed would like
Source: Federal Reserve, Bloomberg, February 2023
The Fed was intent on striking a somewhat hawkish tone as a result. Chair Powell reiterated that “a couple more hikes” are still needed and stated “I don’t see us cutting rates this year”. The Fed also left a reference to “ongoing increases” in rates being “appropriate” unchanged from the last meeting. It also stated it is now considering the “extent” rather than “pace” of future hikes, highlighting the terminal rate as a key source of uncertainty.
One consideration for the Fed is that the last three rate hikes have been met with loosening financial conditions (Figure 2), which has made it harder to transmit tighter policy into the real economy. However, Powell did acknowledge that financial conditions have still “tightened considerably” overall since the Fed began its hiking cycle.
Figure 2: The last three Fed hikes have failed to tighten financial conditions, counter to the objective
Source: Federal Reserve, Bloomberg, February 2023
Slowing economic data has helped lead to market optimism on fewer rate hikes
Markets had been responding to signs that Fed policy is finally showing signs of slowing the economy.
GDP slowed from 3.3% in Q3 to 2.9% in Q4. The overall figure masked the fact that almost all components cooled significantly, with the volatile “change in inventories” measure the only major exception.
Elsewhere, employment growth has continued to be strong led by rebounding sectors like leisure and hospitality, which still employ fewer people today than pre-pandemic. Tech sector layoffs are not yet showing signs of spreading.
However, cracks are starting to show in a notable area: temporary employees (Figure 3). During a slowdown, conventional wisdom states employers neglect to renew temporary employment contracts before actively dismissing other workers.
Figure 3: Temporary employees are considered the first to be laid off in an economic slowdown
Source: Bureau of Labor Statistics, January 2023
Admin and support staff have also been declining, indicating firms may be belt-tightening by shifting these burdens to other staff. Overall, average hours worked is also at its lowest level since the early days of the pandemic in 20201.
Wage growth is moving in the right direction for the Fed. Average hourly earnings growth is running at 4.6% year-on-year, the lowest since September 2021. This week, the employment cost index edged up 1%, less than expected and the slowest since Q4 20211. The Atlanta Fed wage tracker is also trending down, currently at 6.1%, from a peak of 6.7% in the summer and the lowest since May 2022. This is particularly important as many of the remaining high inflation components of interest to the Fed are particularly wage-sensitive.
These signs are encouraging, even if there remains a ways to go. This morning’s job openings data showed there are 1.9 jobs for every unemployed person, well above pre-pandemic norms of 0.7 to 1.22, while the unemployment rate is still around record lows of 3.5%2. Powell described the labor market as “extremely tight”.
The Fed has almost caught up with “Taylor Rule”-implied rates
Fed policy is now close to the optimal rate level implied by a modified version of the “Taylor Rule” (which uses the unemployment rate and core PCE inflation rates as inputs) (Figure 4).
Figure 4: We believe the Fed will need to keep rates elevated to compensate for lost time
Source: Insight, Bloomberg, Federal Reserve, Bureau of Labor Statistics, February 1, 2023. Insight assumes a long-term neutral rate policy rate of 2.5%, a targeted inflation rate of 2% and a rate of unemployment under full employment of 3.5%.
Although the Taylor Rule implies rate cuts should follow, we expect the Fed to keep rates elevated to be more confident that the above target inflation cycle is over. Powell reiterated that the Fed believes policy is “not sufficiently restrictive” and “we have a lot of work left to do” on inflation and expressed concerns about doing “too little”, noting he feels it is easier to correct overtightening than under tightening.
Although we believe core inflation is likely to improve to the 3% to 4% region by the summer, keeping it there and achieving the “last mile” journey to the Fed‘s 2% target remains difficult. As such, Powell made sure to emphasize that the Fed is committed to reaching target inflation (not just falling inflation) and that the central bank needs “more evidence” that inflation is falling in a “sustained” fashion.
Keep an eye on the Fed’s ongoing “quantitative tightening” efforts
While markets have focused on policy rates, the Fed has been continuing its quantitative tightening (QT) operations (Figure 5). This is significant as the Fed’s asset purchases have supported financial asset prices and helped suppress volatility in recent years.
Figure 5: The Federal Reserve balance sheet is shrinking, meaning less support for financial asset prices
Source: Federal Reserve, Bloomberg, Insight, February 2023
According to the most recent primary dealer survey, on average, participants expect the Fed’s balance sheet to reach ~$6.5trn from $8.5trn today. At the current rate, it will approach this level by summer 2024. Although this means a historically high level of central bank liquidity will remain in the financial system, it highlights how markets will potentially be unable to count on the return of the “Fed put” for some time yet. Therefore, we believe continued bouts of volatility in financial markets cannot be ruled out.
The Fed’s communication challenge will only get tougher
As the Fed continues its policy downshift and edges closer to what may be its terminal rate, we believe investors need to watch economic and Fed speakers carefully.
Over the next few meetings, we do not think the Fed’s communication challenge will get any easier. There may even be potential for differing views between Chair Powell and some regional Fed presidents. The composition of the Fed may also change soon, with rumblings that President Biden has earmarked Fed Vice Chair Lael Brainard as the next National Economic Council advisor. Brainard is frequently considered the most dovish member of the committee, and her potential departure could make for a more hawkish Fed overall.
Ultimately, while the Fed has made progress, it has not yet won the war on inflation, and we see markets as too optimistic about the trajectory of rates in 2023 and beyond. As such, we believe investors should tread carefully as the Fed continues its efforts to bring inflation to target.