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Is The Fed Preparing Or Panicking?

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Markets are awash with speculation surrounding the Fed and what they’ll do this year. And rightly so.

The Fed’s decisions will impact assets across the entire risk curve and reverberate around the globe. It’s probably something to keep a really close eye on…

That said, analysis asking “will they hike two or three times this year?” and focusing solely on the CPI numbers will fall short of the mark.

There’s lots more going on. Before looking forward we first need to look back and put the past few months into context. The speed of the policy pivot from the Fed over these past three months has been extraordinary.

Quick recap:

October Meeting: The last time they were merely talking about tapering

“a gradual tapering process that concluded around the middle of next year [2022] would likely be appropriate,

November Meeting: Tapering begins at $15bn per month pace (which would see QE end in June 2022).

“The Committee judges that similar reductions in the pace of net asset purchases will likely be appropriate each month, but it is prepared to adjust the pace of purchases if warranted by changes in the economic outlook.”

Before the month was out, Fed officials were already talking about picking up the pace. By the end of November Chair Powell had retired the ‘transitory’ inflation label.

December Meeting: Doubled pace of taper to $30bn per month (which would see QE end in March 2022).

“The economy no longer needs increasing amounts of policy support,”

Officials saw three 0.25% rate hikes in 2022 according to the “dot plot”

Fomc Participants

Which brings us to the present day. Powell’s comments to the Senate Banking Committee this week centred on high inflation:

“… the economy no longer needs or wants the very highly accommodative policies that we’ve had in place.”

Which has led to speculation that the Fed will end QE even sooner than March, potentially pulling the rug as soon as the 26th of January meeting.

This clears the way to definitively start rate hikes as soon as the next meeting on March 16th.

Ahead of the blackout period, Fed officials have been shouting from the rooftops…

“WE ARE GOING TO HIKE IN MARCH SO DON’T BE SHOCKED OK?”

Markets already assign high odds of a 25bps hike in March. Operation ‘Expectations Management’ has been a massive success:

Target Rate Probabilities

What’s got the Fed so spooked?

Clearly there’s something else going on beyond “higher prices” to justify this sudden acceleration, the rapid withdrawal of stimulative policies and the retiring of ‘transitory’.

Fears of a wage price-spiral taking hold are absolutely top of mind.

Wages increase, company profits are squeezed, so companies raise prices. Workers demand higher pay to compensate for price hikes and the cycle repeats until something breaks:

Wage Price Spiral

Many companies report having to increase wages to attract workers over the past year. And that trend is expected to continue.

According to the latest conference board survey US CEO’s see worker shortages as their top external challenge for 2022

External Challenges In 2022

And the top internal challenge? Attracting and retaining talent is priority #1 across the world

Internal Challenges In 2022

All of which increases the likelihood of higher wages.

The best way to attract or retain workers is to pay them more.

Image

Why would the Fed want to stop this? How can paying people MORE possibly be bad for the economy?

Essentially, if the balance of power shifts too quickly to workers, it can destabilise the economy.

If companies can’t depend on workers to stick with them for longer than a few months before they jump ship to the next highest bidder, that means continuously training and integrating new staff.
If production keeps stopping (e.g. due to strikes), activity and productivity will slow. As this filters through to different sectors of the economy it creates uncertainty and instability.

At some point, it simply becomes unsustainable. Despondency sets in and things start breaking. Hiring slows as firms try to do ‘more with less’, the economic gears seize up and the damage can be long-lasting.

Usually these dynamics will develop over years rather than months, but this entire pandemic period has thrown everything into disarray. There’s huge uncertainty about how long this relative power-shift will last.

It’s not even about unions and collective bargaining

Union And Non Union Workers

Source: Yardeni

The last employment cost index (ECI) at the end of October certainly put the Fed on high alert (and was likely a key driver of the shift in the Fed’s approach):

ECI: “Wages and salaries for civilian workers in the US increased 1.5 percent on quarter in the three months to September 2021, the most since the first quarter of 1984, following a 0.9 percent rise in the previous period

The chart tells the story:

US Labor Statistics

The increases from the previous two quarters at 1% and 0.9% were already at the high end of ‘normal’ for the past decade. In isolation, those two prints could probably be explained away by economic ‘re-opening’.

Q3 was a whole new level!

Usually this isn’t an important data point. Released quarterly, it’s been pretty stable and boring either side of 0.6% for the past 10 years.

In the current market context, the ECI is right in the market spotlight

It would be no surprise to see the Fed double-down on the aggressive rhetoric if this reading comes in hot again (and it probably will).

The costs of Fed inaction right now are far higher than taking this approach.

A little short-term pain now paves the path to a longer-lasting expansion once labour supply and demand are more evenly matched.

Powell’s comment at his Senate confirmation gave a nod to this:

“We will use our tools to support the economy and a strong labor market and to prevent higher inflation from becoming entrenched.”

Brainard backed him up, adding:

“Our monetary policy is focused on getting inflation back down to 2% while sustaining a recovery that includes everyone. This is our most important task,”

So far, so clear. Full steam ahead with rate hikes until further notice.

What Does The Fed Want To See?

Fed Powell

WTF bro? WHY? It’s complicated.

Let’s explain that meme with another meme:

Meme

Imagine three million people return to the labour force

One million get jobs (employed)
Two millon register as seeking work (unemployed)

Good News! Economy has added one million jobs!

Bad News! Unemployment Rate has increased!

More good news! If the economy is running well, those two million will find jobs in no time, worker shortages will ease and overall productivity increases!

This isn’t just theoretical. Similar happened in South Korea this week

More workers should lead to lower wage pressures. A large part of the tight labour market story is the lower participation rate, flatlining at 61.9% vs 63.4% pre-pandemic.

Labor Force Participation Rate

Some argue that this is an inevitable and permanent outcome. As the population ages, more people retire, so there are fewer workers. It’s a fair argument.

Percentage Of Retired Population

Even so, it’s not clear that the economy is already at maximum employment. The prime-age participation rate is still below pre-pandemic levels.

Labor Force Participation Rate 25-54 Yrs

It’s not unreasonable to think that as fiscal stimulus and savings dry up, households will start to feel the pinch, as mentioned here

In theory this means more people will return to the workforce. Covid fears are easing now and private companies cannot mandate vaccines so the reasons for people NOT to work are disappearing.

All of which COULD see wage growth slow as more people compete for work.

Even if they get back to work, it might not be enough to actually solve the overall worker shortage.

Fed’s Barkin says this is a chronic problem.

“I do think this is a long lasting phenomenon, and a lot of it has been predicted for years with baby boomers retiring and all the rest of that, and immigration slowing,”

“Legal immigration can add to the US workforce and help grow the economy”

The US Chamber of Commerce called the current worker shortage a ‘crisis’ and proposed doubling immigration…

“We must double the number of people legally immigrating to the U.S. And we must create a permanent solution for the “dreamers”—those young men and women who know no other home and who contribute to their communities, but whose legal status is in limbo.”

So, that’s the worker side of the picture covered.

Short version: More workers = competition for jobs = wages still growing (but at a slower rate) = more sustainable, long-lasting economic expansion.

Back to the title question: Is The Fed Panicking Or Planning?

Both. They’re still working with a lot of uncertainty. Take Governor Waller’s comments:

“Three hikes is still a good baseline; we will have to wait and see what inflation looks like in the second half of the year,”

“If it continues to be high, the case will be made for four, maybe five, hikes,” he said, but added that if inflation abated — as many forecasters including him expect it will — “then you could actually pause and not even go the full three.”

So… Anywhere between two and five hikes is possible. Thanks for the insight?

Seriously, it highlights the wide range of possible outcomes this year.

Three baseline scenarios I’m considering

As You Were: Supply chain issues, worker shortages continue to stoke inflation. Fed keeps hiking and introduces QT until demand slows > Recession?

Faux-Recovery: Pandemic distortions ease, no fiscal support, economy slows due to lower demand. Fed hikes now create room for later easing.

Goldilocks: Workers return, wage growth and supply chains stabilise. Solid demand supports corporate margins and continued economic expansion. Fed will try to ‘manage’ economy via slower paced (or pausing) rate hikes & QT

Summing up, even though the speeches and headlines are all focused on inflation, the Fed still cares about the employment side of the dual mandate, perhaps now more than ever.

Inflation was last years focus. This year, it’s all about employment and wages.

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