You should never aspire to give a child a bicycle at Christmas. It will be misinterpreted as a promise, possibly leading to tantrums.
It appears that Fed chair Jay Powell did just that to the markets. Earlier last week, in a speech to the Brookings Institute, Powell suggested that interest rate rise could slow, from 75bps to 50bps, ‘…as soon as the December meeting’. Stock markets jumped.
But strong labour market data on Friday suggests that this -let’s call it an aspiration- may be premature. Stock markets fell, with market commentators on Bloomberg accusing Powell of having ‘miscommunicated’ earlier in the week.
But a case can be made that investors only heard the part of Powell’s Brookings speech they wanted to hear. They disregarded the caution that the words ‘…as soon as the December meeting’ was couched in.
In particular, they disregarded his warning that even though core and headline CPI inflation are slowing, reflecting slower growth and tighter monetary policy, ‘…we have not seen clear progress on slowing inflation.’
The Fed is offering a more cautious approach to rate hikes, nothing more
Friday’s labour market data illustrates why the Fed expects inflation to remain well above its 2% target during 2023. And until the slack is created in the labour market (i.e., we have a rise in unemployment), any talk of an easing of monetary policy by the Fed should be interpreted in the same way that Powell’s Brooking speech should have been interpreted, as aspirational and not a promise.
Friday’s labour market data showed non-farm payrolls increased by 263,000 in November, much higher than the consensus forecast of 200,000. The Fed calculates that 100,000 new jobs are required each month to keep pace with population growth. Therefore, it looks at job growth falling below that 100,000 number as a prerequisite for a rise in unemployment (which was unchanged in November, at a mere 3.7%).
Meanwhile, monthly wage growth increased in November by 0.6%, which was higher than in October. The annual year-on-year rate is now 5.1%. This reflects continuing tightness in the labour market, as strong demand for labour hits the barrier of limited supply. The U.S. has a lower labour participation rate than before the Covid-19 pandemic, largely due to early retirement amongst the 50-plus cohort (a similar theme is found in European labour markets). Reduced immigration has also affected the supply of labour.
The suggestion of a slower pace of hikes from December first came from the Fed at its last meeting in November. But it was a nuanced message. The Fed wants to see the impact of earlier rate hikes on the economy and will look to slow the pace of future hikes as it waits for the evidence. Falling CPI inflation allows this to happen. The slower pace of rate hikes was aspirational, not a promise.
The Fed also said that markets were underestimating the likely terminal rate of U.S. interest rates and that the Fed’s September ‘dot chart’ -which suggests a peak of 4.6% in mid-2023- was also underestimated. Investors should prepare themselves for a higher terminal rate, given the tight conditions in the labour market. Market expectations of the terminal rate rose in response to 5%. That part of the message appeared to be lost on the stock market in the days that followed.
Powell’s Brookings speech echoed the November Fed meeting’s message, saying that monetary policy takes time and that it makes sense to moderate the rate hikes as they go higher. He cannot be accused of having misled the market.
A more cautious approach by the Fed to rate hikes is justified, but until slack appears in the labour market, it is best for the Fed not to be too public in its musings. The markets, like children, all too readily misinterpret such aspirations as promises.
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