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Wall Street Futures jumped Monday further on hopes of slower Fed hikes, China reopening, and soft landing optimism. Although for the last few days, ECB officials are sounded more hawkish than their Fed counterparts, European stocks are also getting a boost from the ‘warm winter’ and drastic fall in NG (Natural Gas) prices, which may prevent an all-out recession in Europe and Russia’ ability to use NG as an economic weapon of European destruction as the continent is heavily dependent on imported/Russian gas for cheap energy sources of winter heating and industrial fuel. But on late Monday, Wall Street also stumbled on Fed pivot optimism as U.S. State Department said Finland and Sweden are ready to join the NATO alliance. This may infuriate Putin/Russia more on Russian security issues.
The market is now expecting slower Fed hikes at +25 bps in the coming months instead +50 bps as U.S. core inflation is gradually easing but still substantially higher than +2.00% targets, while employment is almost at maximum levels. Fed will now go for now around a 5.25-5.50% terminal rate by May-June’23 and then hold there for at least till Dec 23-June’24 to bring down core inflation back to +2.00% targets, ensuring minimum damage to the labor market (employment) and overall economic growths; i.e. soft/softish landing despite substantial rate hikes to bring price stability.
On Friday, just ahead of Fed’s blackout period for the 2nd February policy decision, Fed’s Governor Waller, an influential FOMC official, indicated a slower pace of rate hikes, but a higher terminal rate than the market is now expecting. Waller said in a speech titled: “A Case for Cautious Optimism”
“It has been close to a year since the Federal Open Market Committee (FOMC) began tightening monetary policy. We began raising interest rates in March 2022 and shrinking our securities holdings in June to bring inflation down to our 2 percent target. Today I thought I would spend a few minutes taking stock of the year behind us and talking about what's next.
A year ago, inflation was elevated and rapidly accelerating and the Fed moved too quickly and dramatically tighten monetary policy. At the end of December, the federal funds rate target was set in a range of 4.25 percent to 4.5 percent, the highest in 15 years. Economic activity, meanwhile, has been holding up well. After shrinking slightly in the first half of 2022, the real gross domestic product grew at an annual rate of 3.2 percent in the third quarter, and monthly data suggest it grew around 2 percent in the fourth quarter. I expect such slowing to continue in this quarter, which is both expected and desirable in our ongoing fight to lower inflation.
The FOMC's goal in raising interest rates is to dampen demand and economic activity to support further reductions in inflation. And there is ample evidence that this is exactly what is going on in the business sector. On the manufacturing side, industrial production declined for the second month in December. And the Institute for Supply Management's (ISM) forward-looking indicators of orders and customers' inventory suggested that further weakening is in train.
Meanwhile, the ISM survey for nonmanufacturing businesses, which had reported expansion since April of last year, indicated a slight contraction in December. This slowdown in services activity was widespread, affecting 11 of 17 sectors in the survey, with significant slowdowns in construction and real estate, two industries heavily affected by higher interest rates. This slowing in business activity is consistent with the FOMC's goal of damping demand and reducing production (?) so that it is in better alignment with the productive capacity of the economy. The goal is not, I would emphasize, to halt the economic activity, and so we will be watching these sectors closely to see how this moderation continues.
Growth in consumer spending has also begun to slow. While that growth was surprisingly strong through most of the second half of 2022, nominal personal consumption expenditures growth slowed to 0.1 percent in November, and retail sales fell 1 percent. We don't have spending data on goods and services for December, but retail sales fell another 1.1 percent. While the latest readings of consumer sentiment from the University of Michigan moved up some from historic lows, I continue to expect that last year's decline in real incomes, along with higher borrowing costs, will moderate consumer spending this year and help return inflation more promptly to the FOMC's 2 percent target. Job one is maintaining the progress we are making in lowering inflation, and moderation in consumer spending will support that progress.
The slowing in output growth has occurred alongside the continuing strength of the labor market. Total nonfarm employment grew 223,000 in December, close to the average of 237,000 a month for the fourth quarter. That is down quite a bit from the monthly increase of 539,000 in the first quarter of 2022 but still a solid growth rate, far above the number of new jobs needed to keep pace with population growth. Employment grew robustly in the leisure and healthcare sectors, where labor shortages are reportedly severe.
While the labor market is strong, it is also tight. The unemployment rate was 3.5 percent in December, matching the low reached before the pandemic, and the lowest in 53 years. But there are signs that demand for labor is moderating. Job openings reported in the November Job Openings and Labor Turnover Survey and job postings from December's Indeed data are down from their recent peaks. Temporary-help employment, which has sometimes been a leading indicator for overall employment, has declined in recent months, but that decrease may be due at least in part to employers opting to hire full-time workers in place of temps to help keep jobs filled.
A robust labor market, despite modest economic growth, is a plus for workers and allows the Fed to focus on lowering inflation. It shows that jobs and income can hold up to the effects of higher interest rates, helping the FOMC continue its efforts to lower inflation to our 2 percent goal by further tightening monetary policy.
A potential downside of a tight labor market is if labor costs, which heavily influence inflation, grow so fast that they slow progress toward the FOMC's 2 percent objective. Wages and other measures of compensation accelerated as inflation surged in the second half of 2021 and wage growth remained high in 2022. But as overall inflation has begun to moderate in recent months, so have some measures of growth in wages and other compensation.
For example, the 12-month increase in average hourly earnings hit a recent peak of 5.6 percent in March (which is when the Fed began raising interest rates) and has been falling gradually and fairly steadily since then, reaching an annual rate of 4.6 percent December. The 3-month annualized change in average hourly earnings—4.1 percent in December—is running below the 12-month rate and is thus a signal of ongoing moderation.
These are encouraging signs, but we need to see continued improvement across various measures of labor costs, because additional moderation is needed to bring inflation down to our 2 percent goal and because a significant escalation in wage growth could drive up longer-range inflation expectations. Those longer-range expectations have been fairly stable through this period of very high inflation, and we want it to stay that way because escalating expectations could drive inflation higher.
Let me turn now to the outlook for inflation. Last week's report on the Consumer Price Index (CPI) showed that inflation continued to moderate in December, which was very welcome news. First, I am going to spell out why this was such good news, and then I am going to turn around and explain why I am still cautious about the inflation outlook and supportive of continued monetary policy tightening.
Overall headline inflation fell a tenth of a percent month over month in December, the first monthly drop since May 2020. The 12-month change in inflation peaked at 9 percent in June and has fallen every month since, to 6.5 percent in December. A big factor in the monthly decline in headline inflation in December was a significant drop in energy prices, which more than offset an increase in food prices.
The FOMC targets headline inflation because food and energy are considerable expenses for most people, but they are more volatile than other components of the index, and by factoring them out, "core" inflation can provide a picture of where inflation is headed. Here also, we are seeing some progress. Yearly core inflation was down in December to 5.7 percent, from 6 percent in November and a peak of 6.6 percent in September. Over the past three months, core CPI inflation has run at an annualized rate of 3.1 percent, a noticeable drop from earlier in 2022.
Another encouraging sign is that higher inflation was less concentrated—the share of categories of different goods and services with inflation over 3 percent has declined in the past several months, from almost three-fourths in early 2022 to less than one-half in December. That's good news because it indicates that broader inflationary pressure across the economy is easing.
Now, here's why I am cautious about these latest results and why I am not ready yet to substantially alter my outlook for inflation. Month-over-month core CPI inflation actually ticked up in December from November and is pretty much where it was in October and where it was in March when we began raising interest rates. Although inflation measured over 12 months has been falling, December's reading is still close to where it was a year ago.
Core inflation was 6 percent year over year (YOY) in January 2022 and was 5.7 percent YOY last month. Thus, it moved sideways all year. So, while it is possible to take a month or three months of data and paint a rosy picture, I caution against doing so. The shorter the trend, the larger the grain of salt when swallowing a story about the future. Back in 2021, we saw three consecutive months of relatively low readings of core inflation before it jumped back up. We do not want to be head faked. I will be looking for the recent improvement in headline and core inflation to continue.
Wages, as I indicated earlier, are another stream of data that I will be watching for evidence of continued progress to help ease overall inflation. Though recent hourly earnings data are a positive development, I need to see more evidence of wage moderation to sustainable levels. The Federal Reserve Bank of Atlanta's Wage Growth Tracker has been running higher lately and has moderated less. The employment cost index for December won't be out until the end of this month. Over time, we need to see wages grow more in line with productivity growth plus 2 percentage points, consistent with the FOMC's inflation target.
Those are reasons that I am cautious about the recent good news, but it is good news. We have made progress. Six months ago, when inflation was escalating and economic output had flattened, I argued that a soft landing was still possible—that it was quite plausible to make progress on inflation without seriously damaging the labor market. So far, we have managed to do so, and I remain optimistic that this progress can continue.
I believe that monetary policy should continue to tighten, but using a comparison I employed in a speech a couple of months ago, the view from the cockpit is very different at 30,000 feet than it is close to the ground. When the FOMC began raising the federal funds rate last spring from near zero, it made sense to move quickly. But after front-loading monetary policy tightening, with many unprecedented 75 basis point hikes in the federal funds rate target, by early December I believed the policy stance was slightly restrictive, and I supported a decision by the Committee to hike by a still considerable 50 basis points. To return to the airplane image, after climbing steeply and using monetary policy to significantly raise interest rates throughout the economy, it was apparent to me that it was time to slow, but not halt, the rate of ascent.
And in keeping with this logic and based on the data in hand at this moment, there appears to be little turbulence ahead, so I currently favor a 25-basis point increase at the FOMC's next meeting at the end of this month. Beyond that, we still have a considerable way to go toward our 2 percent inflation goal, and I expect to support the continued tightening of monetary policy.
As the U.S. economy, labor market as well as core inflation is cooling down, but still, substantially above +2.00% targets, Fed may shift to slower rate hikes (calibrated tightening) to ensure a soft/softish safe landing instead a bumpy hard landing (an all-out lingering recession). Thus Fed may now go for +25 bps rate hikes each on 2nd February, 22nd March, and 3rd May to arrive at a preliminary terminal rate of +5.25% (from present +4.50%) in line with the December SEP.
The FFR is now forecasting an almost 95% probability of a +25 bps rate hike on 2nd February and Fed is not engaged in ultra-hawkish jawboning to negate that forecast just ahead of the blackout period. History shows that Fed never goes for any policy rate action against the market consensus or without taking the market into confidence (through well-orchestrated jawboning/communications). This ensures orderly market reaction/function.
Looking ahead, Fed will watch the trajectory of core inflation from Dec’22 to May’23 (6M rolling average). Presently, the core CPI average is around +6.00%, while the December reading was +5.70%. If the 6M rolling average of core CPI indeed comes down to around 5.00% by June’23, then Fed may keep the terminal rate around +5.25%. Alternatively, if the 6M rolling average of core CPI falls to +5.25%, then Fed may go for another +25 bps hike in June for a terminal rate of around +5.50%. In the worst-case scenario, if the 6M rolling average of core CPI sticks to around +5.50% or +5.75% by May’23. Then Fed may opt for further rate hikes @25 bps to reach +5.75% or +6.00%.
As per the pre-COVID trend and comments by Fed Chair Powell, Fed may like to keep the terminal rate at least above 25 bps of average core CPI to have a real positive rate (wrt at least core inflation). And if average core CPI indeed falls well below 4% on a sustainable basis by June’24 due to rate hikes, QT-financial tightening, and easing of supply disruptions, then Fed may also go for calibrated rate cuts ahead of Nov’24 U.S. Presidential election to boost up the economy and employment/labor market. In the meantime, Fed is ready to allow the U.S. unemployment rate to soar to 4.5-4.7% to bring down core inflation towards +2.00% targets.
Fed is now signaling a soft/softish landing; i.e. solid labor market and steady economic growth despite considerably higher borrowing costs. As the balance sheets of both U.S. Households and Corporates are now rock solid (deleveraged) and cash-rich, consumer spending is also robust. The U.S. economy is now slowing down. But the U.S. employment is still almost at the Fed’s maximum level despite some cooling, while average core inflation at around +5.5% (core CPI/PCE) is still substantially above the Fed’s price stability target of +2.00% without any meaningful sign of cooling. For a goldilocks-type U.S. of economy, Fed needs at least 4% unemployment and a 2% core inflation rate on average to fulfill its dual mandate of maximum employment with price stability.
As U.S. core inflation is now around +6.0% on average in 2022, substantially above Fed’s +2.0% targets but the average unemployment rate at 3.6% is almost around pre-COVID/lifetime low of 3.5% and also below Fed’s preferred/goldilocks run rate 4.0%. Thus Fed now prefers to bring core inflation down to +2.0% levels by calibrated tightening as there is enough policy space for a maximum employment mandate. Fed is now even ready to tolerate 4.5-4.7% unemployment levels (from present 3.5-3.7%) to bring core inflation down to around +2.00% (from present levels of +6.00%).
Fed will do this job by keeping financial (Wall Street) stability in a calibrated manner/jawboning as the financial market functions on expectations, not the real outcome. Fed may go for calibrated tightening (75-100 bps) by Feb-May-June’23 for a terminal rate of 5.25-5.50% and then pause. Fed is now emphasizing the proper balancing of inflation management and economic growth for a softer/softish landing.
Thus Fed is now jawboning the market for a real positive rate (at least wrt average core inflation -CPI/PCE) of +5.50%. Fed is now preparing the market for a slower rate of increase, but higher for longer. Fed will now focus on an appropriate terminal rate, restrictive enough (real positive) to bring down inflation towards the +2% target over the medium term. When the cost of borrowing turns real positive or there is an elevated cost of capital, overall economic activity/demand bounds to slow down, leading to lower inflation (as lower demand will try to catch up with the presently constrained supply capacity of the economy). Also, a real positive rate would encourage savings than spending, negative for inflation.
As per Taylor’s rule, for the US:
Recommended policy rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(5.5-2.00) =0+2+3.5=5.5%
Here for U.S. /Fed
A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= average core inflation=5.5% (average of core PCE and CPI)
Thus Fed will hike further 75-100 bps by Mar’23 to 5.25-5.50% depending upon the actual core inflation trajectory in Q1CY23. Fed is now preparing the market for a possible series of smaller hikes (25 bps) and pauses down the road after reaching around 5.25-5.50% by May’-June’23. But Fed also seems confused about levels of an appropriate terminal rate and may continue to debate. Fed may keep the terminal rate around +5.50% for at least 2023 to bring down core PCE inflation back to +2.00% on a sustainable basis.
Fed is now preparing the market for terminal rates around 5.25-5.50% and stay there until at least Dec’23 or Mar’24. And Mar’24, if core PCE inflation stabilizes around +2.0% targets, and unemployment goes up around 4.5%, then Fed may also go for some rate cuts and even launch QE-5 ahead of Nov’24 U.S. Presidential election to have a ‘feel good’ factor for both Wall and Main Street. The U.S. is now paying around 11% of its tax revenue as interest on public debt, while Europe, U.K. China pays around 5.5% and Japan around 15%. As a developed economy and the world’s largest debtor, the U.S. has to ensure lower pre-COVID borrowing costs of around 8.5% in the coming years; otherwise, it would be seen as a fiscal blunder.
Fed will consider at least two-quarters of average core inflation in 2023 for its rate actions. After reaching +5.25% by May, Fed may pause if core inflation trends a definitive downtrend and falls below +5.00% on a sustainable basis; otherwise, Fed may even go for +6.00% repo rates by Sep’23.
Fed’s Bullard wants a 5.25-5.50% terminal rate by June’23 and then a pause to assess. Bullard also wants an extended period of QT. In contrast, most other Fed officials including Waller, Brainard, Mester, and Harker seek a terminal rate of around 5.00-5.25%. As the current US10Y bond yield is around +3.40%, much lower than the Fed’s projection of a terminal rate of +5.25% till at least Dec’23, the market is now expecting Fed rate cuts by late 2023. Thus Fed is now jawboning in a balancing way so that 1Y inflation expectations do not jump again after the recent easing. Fed is aiming for price/Wall Street stability along with a soft/softish landing. The market is now expecting +25 bps rate hikes each in Feb, March, and May for a terminal rate of +5.25% by May’23. On Friday Fed’s Waller also virtually started the debate about rate cuts in 2024 in his Q&A session.
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