2022 has proved to be a roller-coaster year for the economy.
After nearly a decade of artificially low-interest rates, and institutions such as the Fed failing to boost inflation to the 2% target, this year has seen prices surge to their highest levels since the 1980s.
Tomorrow, the FOMC shall convene for the final time in the calendar year.
Crucially, being the end of the quarter, the market will look forward to the issuance of the much-awaited Summary of Economic Projections, and the dot plot, which provides a breakdown of the expectations of each of the members.
For a detailed look at the current summary of economic projections, interested readers can view this article from September.
The December gathering will allow market participants an inside view into target levels for interest rates, and how long decision-makers anticipate them to remain elevated into the future.
Doves vs hawks
In June, CPI skyrocketed to 9.1% (which I wrote about here), prompting the first of four rate increases at thrice the traditional 25 bps.
Thus far, the FOMC has raised rates from zero per cent for seven consecutive meetings to the 3.75% – 4% band.
The near-complete loss of price stability earlier in the year, aggravated by runaway fuel prices, resulted in unanimous decisions to hike rates on the part of the FOMC members.
However, in the most recent print, CPI numbers moderated to 7.1% (available here), lower than the 7.7% during the previous month.
Fresh data released by the NY Fed also pointed to easing inflation expectations.
Source: NY Fed
In addition, a recent report by the University of Michigan showed that year-ahead inflation expectations eased to a 15-month low of 4.6%, complicating the dynamic between the hawks and the doves serving on the committee.
The market broadly expects the FOMC to continue to hike rates, but to do so by 50 bps in the December meeting, instead of 75 bps.
Source: CME Group
Although the anticipated rate decision this week is largely crystallized in the minds of financial market participants, the projected rate pathway is what will draw the most interest.
One of the key questions around the future rate pathway is the impact of lags, which I discussed in this piece.
In general, economists agree that monetary decisions take time to filter through the economy.
For the dovish camp, easing headline inflation following the unprecedented rate hikes is a sign that the Fed should consider slowing monetary tightening, or even pausing, to fully assess the impact on the broader system.
If the Fed continues upon its intended rate path of reaching near 5% levels to tackle inflation, dovish members fear that this could prove damaging or even catastrophic to crucial sectors that are highly sensitive to interest-rate changes including housing, auto, as well as to consumer spending.
Yet, on a historical basis, inflation levels are still well above what we may normally see in the tightening cycle.
In terms of the sustainability of a higher rate regime, which Chairman Powell appears to be committed to, he will be hoping for a relatively consolidated dot plot, where most members agree that rates must stay elevated in 2023 to maintain price stability.
A scattered dot plot, on the other hand, would likely signal much more friction ahead in negotiating with other FOMC members.
The exit of James Bullard, President of the Federal Reserve Bank of St. Louis from the FOMC later this year, may mean the loss of a key ally of the tightening agenda.
Danielle DiMartino Booth, CEO of Quill Intelligence, and an advisor to the Dallas Fed from 2006 to 2015 believes that things may get very tricky if as inflation indicators ease, John C. Williams of the New York Fed, and Lael Brainard of the Board of Governors, both traditional doves, were to find common ground.
The Fed’s terminal rate will likely continue to remain near 5%.
Shifting the target higher to say 5.5% would commit the Fed to hike through the summer of 2023 and lose much-needed flexibility in the meetings ahead.
Further, the Fed could risk losing widespread credibility if they expect interest rates to shift even higher than target at this juncture.
However, if rates are raised by 50 bps this week, it is highly unlikely that monetary actions will stall immediately, signalling that the market can expect a bare minimum hike of 25 bps in the first meeting of 2023.
Although financial markets have been relatively buoyed off late, the main obstacle in Powell’s path would likely be a complete unwinding of the labour market.
The Survey of Consumers published by the University of Michigan last month stated,
About 43% of consumers expected unemployment to rise in the year ahead, a share last exceeded at the start of the pandemic and before that in 2009.
Booth notes that a study by the St. Louis Fed found that a significant portion of jobs advertised, targeted highly skilled labour, with a view to poaching talent from competitors.
Although this is not a new practice, the study indicates that there has been a sharp increase in such talent-seeking behaviour on the part of firms in the past two years.
This would suggest that many reported openings are really a transfer of labour from one job to another and not the availability of newly created jobs.
Source: St. Louis Fed
A Bloomberg article also found that through the Fed’s post-war history, there are no instances where unemployment rates have risen between 0.5% and 2% during a business cycle.
Put another way, to pull down inflation to its 2% target, the Fed will have to go for a hard landing and cut the labour market down to size.
With reports of plenty of small business closures underway, the bulk of positions that are meant for non-college-educated and less skilled workers may already be largely filled.
In December data, year-on-year initial jobless claims have turned positive, a likely precursor of things to come.
Source: US FRED
The outlook on living standards has begun to worsen as well, as 58% of consumers earning in the lowest third of incomes prepare to cut back on spending in the next 12 months.
Perhaps even more consequentially, the same survey, shows that 47% of top earners are also looking to draw down spending in response to high inflation, which would prove catastrophic for job seekers in the coming quarters.
Housing, holiday spending and Q3 GDP
Housing, being highly sensitive to rate hikes has also seen prices crumble in jurisdictions across the country, following higher mortgage rates which I covered in a piece here.
The Case-Shiller Index (which you can read about here) which was strongly positive just a few months ago, marked a hard turn and fell below expectations.
Consumer spending in the holiday season this year is expected to slow considerably, with the CNBC All-America Economic Survey, showing that 41% of respondents plan to lower their spending on account of inflation and weakness in the labour market as opposed to 27% in the previous year.
Further, there was a 10% decline in expected gift expenditures as direct fiscal support from the government has begun to dry up.
Booth also noted that the rise in Q3 GDP into positive territory of 2.6% (commentary of which can be found here), is not an anomaly, but in fact, is a feature of most recessionary periods.
The improvement in GDP will likely be short-lived and reflects temporary factors such as high exports of energy to Europe.
The FOMC will be raising rates by 50 bps in this week’s meeting, and will almost certainly follow this up with another hike in the first meeting of 2023.
Despite the weakening of expectations and cracks showing in various markets, the Fed is likely to state that rate consolidation will be necessary for an extended period.
With fresh rotations in the FOMC’s composition, Jay Powell may find it harder to balance his tightening strategy with the entry of more dovish voices.
In such an atmosphere, it is difficult to imagine that the Fed will continue to steadfastly tighten policy and maintain high rates, while job losses will inevitably increase.
Bank of America’s Head of Global Economic Research, Ethan Harris, believes that the Fed’s tightening could bring inflation down towards 3% – 4% levels, but reaching the 2% target may not be possible even over a 2-3 year horizon.
Another crucial component is the phasing out of business income tax refunds by the US government in 2023, which have thus far amounted to well over $100 billion in 2022, and boosted spending among small business owners, often in the luxury consumption segments.
This shortfall in the following year would make financial conditions much tighter, with Booth noting,
The gravy train is pulling out of the station.
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