The Battle Against Inflation Continues
Inflation is slowly moving in the right direction, but when it comes to monetary policy, the fight isn’t over yet.
Few factors carry as much weight in monetary policy decisions as inflation. The latest data shows that inflation, although no longer the cause of intense concern it was in the past year, is proving more stubborn than initially expected. Looking at various measures of inflation and their momentum, it’s clear that the downside momentum we’ve seen this year appears to be losing steam when examined through the lens of a three- and six-month annualized growth rate basis compared to current year-over-year numbers, except for Core PCE.
We can also see that much of the downside momentum in inflation is being driven primarily by Owners’ Equivalent Rent—the largest component of the CPI basket. In addition, the recent volatility in inflation is being fueled by the latest nosedive in energy prices.
While OER is expected to continue declining over the next 18 months, the current plunge in oil and gas prices is likely to impact CPI for only a short period. With wage growth remaining a bit more resistant than the Fed would prefer and my leading inflation indicator showing an upward turn, it suggests that the downward pressure from OER will be counteracted by upward inflation pressures from the goods and services sectors.
Does this mean the current inflationary pressures justify more rate hikes? No, that’s not the case. When we compare historical relationships between Core Inflation and the Federal Funds rate, a Federal Funds rate above 5% seems more than reasonable given Core CPI tracking at 4% YoY. If anything, in relation to inflation, the course of monetary policy in the 2020s until now has yet to reach levels historically considered tight.
Steadfast Tightness in the Jobs Market
Similar to inflation, the labor market is gradually cooling, but it’s hard to argue that it’s cool enough to warrant rate cuts.
On the positive side, job openings have significantly declined from their highs in 2022 and are clearly moving in the right direction. However, there are still approximately 1.3 jobs available for every unemployed person, and job openings remain significantly higher than pre-COVID levels while the number of unemployed persons has barely budged from cyclical lows. These dynamics are typical of a tight jobs market, just as tight monetary policy is typical in such conditions.
Employment and inflation data are both backward-looking, showing where the economy has been, not where it’s headed. But for monetary policy, the current state of the jobs market, inflation, and the economy as a whole takes precedence.
Even though we’re experiencing downward momentum in many jobs market indicators, particularly job openings, it’s not universal. Wage growth momentum is notably negative at the moment but is still growing at a solid 5.2% on a year-over-year basis. The overall employment growth remains quite stable, and average hourly earnings, despite showing some slight downward momentum, still show growth of over 3% on all measures. This doesn’t signal a jobs market in need of rate cuts.
However, the Fed may find solace in Unit Labor Costs, which are critical in central bankers’ forecasts and decision-making. This measure indicates the actual cost a business pays its workers per unit of output. For the Fed, this reflects a soft landing—a low unemployment rate coupled with wage growth returning to normal levels, although there’s still some distance to go in this respect.
But, as I observe the leading indicators of wage growth through my composite leading indicator, it seems that the rapid decline in wages thus far appears to have gotten ahead of itself for now.
While the downward trend in wage growth and unit labor costs is enough to steer clear of additional rate hikes, the overall jobs market still doesn’t allow for any outright cuts. The latest jobs numbers from November from the BLS strongly support this view. The unemployment rate dropped back down by 20 basis points to 3.7%, a figure still roughly 1.5% lower than levels that have historically heralded rate cuts.
## Fed in Strong Position to Withstand Economic Challenges
The economy may be rumbling with signs of weakness in some sectors, but there’s no justification for the Fed to swoop in with rate cuts, according to the latest analysis. The recent performance of the jobs market and inflation trends suggest that the overall economic landscape doesn’t cry out for a shift in monetary policy. The economy is still humming along nicely, undeterred by potential headwinds brewing in specific sectors.
### A Resilient Economy
Amid indicators of a slowdown in manufacturing and retail sales, the broader momentum in major areas of the economy, such as consumption, incomes, and employment, reflects extraordinary resilience. This robust performance paints a picture of an economy that’s weathering the storm of potential challenges while continuing to march forward.
## No Time for Easing
Assessing the economic outlook through the Fed’s mandate, coupled with an eye on factors like asset prices and credit conditions, points to an uphill battle for anyone advocating for a dovish stance. Despite some easing in financial conditions, the current state of inflation and employment doesn’t provide the wiggle room for the Fed to consider a shift in monetary policy. In fact, financial conditions would need to worsen significantly for the Fed to even think about easier monetary policy.
### Looking at Indicators
Evaluating economic surprises, economic growth relative to its target, and trends in unemployment and inflation collectively demonstrate that a dovish approach to monetary policy is currently unwarranted. These indicators align with the broader sentiment that the time isn’t right for any significant shift in the Fed’s stance.
## Stable Financial System
Despite the recent banking crisis and continued rate hikes and QT, the financial system seems to be on solid ground. Commercial bank reserves, a key measure of financial stability, have actually increased over the past six months. This bolster in reserves should ensure the smooth functioning of the financial system, offering some breathing room for the Fed to maneuver.
### Banking Stability and Tumultuous Deposits
The movement of funds away from commercial bank deposits towards higher-yielding alternatives has raised some concerns, yet the Fed’s interventions seem to be holding up. The Bank Term Funding Program, designed to counteract the fleeing deposits, appears to have plugged the hole in the financial system for the time being.
In the face of potential economic challenges, the Fed stands on solid ground, armed with the information and resources needed to make informed decisions. While some storm clouds may be on the horizon, the Fed’s vigilance and strong position offer a comforting reassurance amid the economic murmurs.
Financial Market Volatility Looms Amid US Treasury Imbalance
The financial market is a jungle, and right now, the US treasury is at the center of an intense tug-of-war. It’s like a high-stakes game of poker where everyone’s bluffing, and the chips are as big as the national debt. The balance of supply and demand in the treasury market is like a ticking time bomb, with potential consequences that could send shockwaves through the entire financial system.
Will Yields Spike?
The prospect of US yields surging is a genuine concern, especially considering the impact of various factors on market stability. The Federal Reserve’s move to undertake Quantitative Tightening (QT), the strengthening dollar dissuading foreign central banks from buying US debt, and the Japanese central bank’s actions incentivizing capital to shift back to Japan, all contribute to an impending imbalance in the treasury market.
Without the Fed’s support, there could be an oversupply of government debt relative to demand, and this has forced the burden onto the US private sector. Hedge funds have emerged as significant buyers of treasuries, engaging in complex financial strategies to navigate this challenging landscape. However, should yields spike significantly due to these dynamics, the market could be staring down a path that might just bring the Fed to its knees.
How High is Too High?
The burning question now is, how far must yields climb before the Fed intervenes? The answer is, quite a bit higher. Despite the level of cash that remains on commercial bank balance sheets and the Treasury’s efforts to reduce the duration of its issuance, the key lies in the fact that an economy with a nominal GDP of over 6% should be able to handle yields of more than 4%.
The situation may seem daunting, but it’s not an immediate threat to the financial system. Rather, it’s a precarious tightrope walk, where the stakes are high, and any misstep could lead to chaos.
Market Predictions and Projections
Adding to the drama is the market’s intriguing performance in pricing. Short-term rate markets have already factored in a ~44% chance of rate cuts as early as March, coupled with a ~77% likelihood of a rate cut by May. Looking further ahead, current Secured Overnight Financing Rate (SOFR) futures are projecting a Fed Funds rate nearly 100 basis points lower by the end of 2024.
While some may find solace in the market’s predictions, it’s important to remember that markets often get it wrong. The widely held assumption of future monetary policy paths has historically been laced with errors, and given the circumstances at play, this time may not be any different.
Conclusion
The current scenario in the financial markets is akin to a high-stakes thriller, with the US treasury market at the heart of the action. The tug-of-war between supply and demand, combined with market predictions and volatility, is a tale that is far from over. As investors and analysts brace themselves for what lies ahead, all eyes are on the treasury market, where every move has the potential to send ripples through the global financial landscape.
