Fed Chair Jerome Powell struck a hawkish tone at the Semiannual Monetary Policy Report to the Congress last week, “The process of getting inflation back down to 2 percent has a long way to go”. While the Federal Open Market Committee (FOMC) decided to pause its pace of rate hikes at the latest meeting, he signaled further rate hikes in the near future. “Nearly all FOMC participants expect that it will be appropriate to raise interest rates somewhat further by the end of the year.”
The word “nearly” is an understatement. The “dot plot” shows only two out of 18 dots project the Fed Funds rate to remain constant at current levels by the end of 2023. Nine project a half-point rate hike, and three project even more rate hikes by year-end. None expect rate cuts.
At the same time, Powell acknowledged during his testimony that shelter costs are lagging components of CPI and PCE. Leading indicators of shelter are falling, which is good news on inflation.
Why is the Fed ignoring leading indicators of inflation, which are falling, while focusing on lagging conventional inflation metrics, which are stable? Is it deliberately trying to engineer a recession?
Signs of cooling
There are numerous signs of economic cooling and disinflation if you know where to look.
Here is CPI Servies Ex-Rent of Shelter, which is a closely watched metric that’s decelerating quickly.
Producer prices, which have no wage or shelter component, are also dropping precipitously. May core PPI for finished goods (blue line) came in at 5.0% and core PPI for final demand (red line) printed a 2-handle at 2.8%.
What about the Fed’s characterization of the labour market as “tight” as a reason for concern for inflation? A near real-time recession indicator was proposed by (then) Fed economist Claudia Sahm. The “Sahm Rule” recession signal is based on surges in the unemployment rate.
Analysis by New Deal democrat found that initial jobless claims lead the unemployment rate. The chart shows the 4-week average of initial claims (red line) and Sahm Rule signals (blue line, above 0 is recession signal). The chart excludes the spike in unemployment during the pandemic, which distorts the scale of the chart and makes it unreadable.
Here is a close-up of initial jobless claims and the Sahm Rule. Initial claims have been rising strongly and we have seen two consecutive weeks where they have beached the recession signal zone. Initial jobless claims is a useful indicator as it’s reported weekly, but it’s also highly noisy and two weeks isn’t enough to make a definitive call that a recession is on the way. The longer-term history also shows that there have been false positives in the past, and we would like to see some persistence in initial claims before making a recession call. Nevertheless, this is a warning flag that the employment market is weakening to be of concern. The title of New Deal democrat’s latest blog post
on the subject was enough to tell the story, “Initial claims: yellow caution flag turns more orange”.
There are other signs that labour tightness is easing. The JOLTS report shows that job openings (blue line) are topping out while the quits/layoffs ratio is falling in an uneven manner. The only caveat is JOLTS reported with a delay and the latest data point is in April,
The most recent Philadelphia Fed survey also revealed important signs of a reduction in the tightness in the jobs market. When businesses were asked when the labour market was improving (for them), the percentage who replied “improved” outnumbered the number who replied “worsened” by 29.4% to 17.6%.
The FOMC analytical framework
To understand the reasoning behind the Fed’s reaction function, you have to understand the FOMC’s analytical framework. The bout of monetary easing left the real Fed Funds rate deeply negative, and the FOMC reacted by raising it to a positive in to? squeeze inflation and inflationary expectations out of the system. Today, the real Fed Funds rate based on headline CPI is positive (blue line) and negative using core CPI (red line). That’s barely in restrictive territory.
The Fed’s wants falling inflation to do the heavy lifting. As the inflation falls but the nominal Fed Funds rate stays constant, the real Fed Funds rate rises as a form of monetary tightening. Should inflation rise, the nominal Fed Funds rate will also have to rise in lockstep. Here’s the problem, monthly core CPI and PCE have been stuck in the 4–5% range for several months.
There is another source of inflation that the Fed may be worried about. That’s the so-called “greedflation”, where companies sacrifice sales growth for price increases. Analysis from the Economic Policy Institute found that corporate profits replaced unit labour costs as the largest component to unit price growth for the post-pandemic period from Q2 2020 to Q4 2021.
Yardeni Research also reported that forward estimates of corporate margins are rising, which is another indication that greedflation may be taking hold.
In the wake of unwelcome inflation surprises in Australia and Canada, whose central banks reversed rate pauses to raise rates, members of the FOMC became sufficiently alarmed that they collectively raised their consensus GDP growth forecast for 2023, lowered the unemployment rate forecast and raised their inflation forecast. More importantly, the downgrade of the year-end unemployment rate from 4.5% in March to 4.1% in June means that the Sahm Rule warning for a recession will not be triggered. By contrast, the May forecast from the Fed’s staff economists has been calling for a recession to start in H2 2023.
In short, the members of the Committee believe inflation risks are rising and recession risks are receding. It’s safe to adopt a more hawkish monetary policy. No one wants to be another Arthur Burns. Better to err on the side of over-tightening and pay the price of a recession than to allow inflation to run out of control.
reported that Chicago Fed President Austan Goolsbee characterized the June pause decision to be a “close call”. Viewed in this context, the skip in June was a compromise decision to satisfy both the doves and hawks on the FOMC. When Powell was asked by WSJ reporter Nick Timiraos why the FOMC decided to skip a rate hike in June but signal a July rate hikes when there was much new data other than an employment and CPI report between meetings, he equivocated and didn’t have a very good answer.
NICK TIMIRAOS. I know you said July is live with only one June employment, with only the June Employment and the CPI report for June due to be released before the July meeting. You get the ECI, after you get the senior loan officer survey, after you get some bank earnings at the end of next month. What incremental information will the Committee be using to inform their judgment on whether this is, in fact, a skip or a longer pause?
CHAIR POWELL. Well, I think you’re adding that to the data that we’ve seen since the last meeting, too. You know, we since we chose to maintain rates at this meeting, it’ll really be a three-month period of data that we can look at. I think it’s a full quarter, and I think you can, you can draw more conclusions from that than you come from any six in a six week period. We’ll look at those things. We’ll also look at the evolving risk picture. We’ll look at what’s happening in the financial sector. We’ll look at all the data, the evolving outlook, and we’ll make a decision.
The only reasonable explanation was the June decision was a compromise and the Fed would raise rates in July, barring any extraordinary events.
In conclusion, I rhetorically asked whether the Fed is deliberately trying to engineer a recession. The answer is a qualified no. The Fed is primarily focused on coincidental and lagging indicators of inflation, which have been sticky, while forward-looking indicators are cooling. The Fed policy mindset is to err on the side of being too tight as policy makers want to avoid the 1970s Arthur Burns blunder of giving up on the inflation fight too early. This is leading to an increased risk of recession which many models indicate is on the horizon. It’s also consistent with the 1980–1982 double-dip recession scenario that I outlined
In light of this week’s cover of The Economist with the title, “The Trouble with Sticky Inflation”, this might be the perfect contrarian magazine cover buy signal for Treasury bonds, which have been stuck in a trading range.