A pause isn’t a pivot

Now that the market has had over a week to absorb the implications of the last Fed rate decision and incoming data since the meeting, here is where we stand.
 

The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.

The May meeting statement allowed for a pause in rate hikes, with the usual nod to data dependency.

The Committee will closely monitor incoming information and assess the implications for monetary policy. In determining the extent to which additional policy firming may be appropriate to return inflation to 2 percent over time,

Since the conclusion of the May meeting, the April Jobs Report came in mixed. While the headline increase in non-farm payroll employment was ahead of expectations, the figures for the previous two months were dramatically revised downward. The April CPI report came in slightly softer than expected. Headline YoY fell from 5.0% to 4.9%, which was below market expectations, while core CPI was unchanged from the previous month at 5.5%. As well, PPI came in softer than expected. Overall, inflation has been slowly decelerating. The target Fed Funds rate of 5.00–5.25% is now above the core PCE rate of 4.2%. Historically, the Fed has kept the Fed Funds rate above its preferred inflation metric of core PCE whenever inflation has been above its 2% target.
 

Is it time for a pause? Under what conditions would the Fed pivot to cutting rates?
 

How hawkish is the Fed?

Before everyone becomes overly excited about the prospect of a pause in rate hikes, the first question to consider is whether monetary policy is sufficiently restrictive. While some Fed speakers, such as Cleveland Fed President Loretta Mester, who is considered to be a hawk, has said that she considers the Fed to be sufficiently restrictive when the Fed Funds rate is above the inflation rate, Fed Chair Jerome Powell equivocated at the May post-FOMC press conference when asked if he considered the latest Fed Funds target is sufficiently restrictive.

That’s going to be an ongoing assessment. We’re going to need data to accumulate on that. Not an assessment that we’ve made that would mean we think we’ve reached that point. And I just think it’s not possible to say that with confidence now. But, nonetheless, you will know that the summary of economic projections from the March meeting showed that in – at that point in time, that the median participant thought that this was – this was the appropriate level of the ultimate high-level of rates. We don’t know that. We’ll revisit that at the June meeting. And that’s – you know, we’re just going to have to — before we really declare that, I think we’re going to have to see data accumulating and – and, you know, make that – as I mentioned, it’s an ongoing assessment.

On the other hand, Powell did allow that monetary policy is tight and he estimates inflation to be at 3% when the latest core PCE reading is 4.2% [emphasis added]:

I think that policy is tight. I think real rates are probably — that you can calculate in many different ways. But one way is to look at the nominal rate and then subtract a reasonable estimate of let’s say one-year inflation, which might be 3 percent. So you’ve got 2 percent real rates. That’s meaningfully above what most people would — many people, anyway, would assess, as, you know, the neutral rate.

(Did he say a reasonable estimate of one-year inflation is 3%?) The key question for investors is whether current conditions are sufficient for the Fed to pause. In addition, when does the pause turn into a pivot to lower rates? Fed Funds futures are now discounting rate pauses for the next two meetings, with a series of consecutive quarter-point cuts that begin at the September meeting.
 

Did the Fed break something?

Arguably, the only reason for the Fed to cut is a marked deterioration in economic growth and a possible recession. It is also said that the Fed usually keeps raising rates until something breaks. Did the Fed break something this cycle that the damage warrants a pivot to rate cuts?
 

The quarterly Senior Loan Officer Opinion Survey (SLOOS), which was released after the FOMC meeting, shows a heightened level of recession risk. Banks are tightening lending standards in a variety of categories for businesses and consumers, which is a signal of a credit crunch. Similar episodes have resolved in economic recessions in the past.
 

The performance of regional banking has become an increasing concern to the market. The KBW Regional Banking Index violated a key support zone and an important Fibonacci retracement level (top panel). The bulls’ only hope is the index can hold at a relative support level that stretches back to 2020 (bottom panel).
 

Moreover, commercial real estate could be an additional source of stress for regional banks, which have high levels of exposure to the sector. In particular, office real estate is a concern as many workers have not returned since the pandemic, and office space occupancy is down substantially. As an illustration, the accompanying chart shows the relative performance of three large office REITs relative to the S&P 500 and to the Vanguard REIT ETF. As the chart shows, office REITs not only have underperformed the S&P 500, they have also substantially lagged other REITs as well.
 

In addition, business inventories have historically been closely correlated with core PCE inflation. Dramatic declines in business inventories have been disinflationary, but such episodes have also coincided with recessions. Will the U.S. economy fall into recession this time?
 

Scenes from small business America

The monthly NFIB small business survey is useful because small businesses have little bargaining power and they are sensitive barometers of the U.S. economy. The results of the April survey broadly reflect our assessment of economic conditions.
 

First, small business confidence is collapsing. While researchers make seasonal adjustments to their data, NFIB does not make political adjustments to its Optimism Index as it tends to be higher during Republican Administrations and lower when a Democrat is in the White House. Nevertheless, the recent trend of falling confidence is instructive.
 

Small business employment is softening from red hot to just hot, which is consistent with what we are seeing in labor market surveys like JOLTS and NFP. This should be comforting to Fed officials as the jobs market is going in the right direction for them.
 

Good news and bad news: The good news is inflation is falling. The bad news is the closely waged services inflation component, which consists mainly of wages, is sticky. A comparison of the Prices and Employment readings shows that prices are falling faster than compensation. In other words, wages are sticky.
 

As well, credit conditions are deteriorating, which is consistent with the recent SLOOS report.

Putting this all together, we have a picture of decelerating inflation and slowing economic growth, but sticky wages that prevent the Fed from meaningfully easing unless there is a catastrophe.
 

Fed Chair Jerome Powell pushed back against that view at the May post-FOMC press conference: “We on the committee have a view that inflation is going to come down not so quickly, that it’ll take some time. And in that world, if that forecast is broadly right, it would not be appropriate to cut rates and we won’t cut rates.”
 

In conclusion, the Fed may pause rate hikes, but it’s unlikely to ease until it’s too late and a crisis erupts. Expect a recession in H2 2023. Such an environment should be supportive of Treasury prices, but create headwinds for stock and commodity prices.