The Federal Reserve’s highly telegraphed move to slow the pace of monetary policy tightening next week threatens to send a message to markets that the central bank is on its way to reining in inflation and steering the economy into a soft landing. It is better for investors to re-evaluate.
Regardless of the pace of monetary policy tightening by the Fed, the most important message the economy is sending right now is that the central bank will probably have to raise interest rates beyond the roughly 5% range that markets expect in order to counteract the current bout of inflation coming back closer. to the target level. This, in turn, suggests that at least a moderate recession seems increasingly necessary for prices to finally cool off.
“We’re heading for a hard landing. It’s a hard sell story because the data looks good,” says Anita Markowska, chief financial economist at Jefferies. “That’s going to change.”
The optimist camp says that combine Mild cooling in October In the consumer price index, the a slight decrease in the demand for labor, The Fed’s downward slope indicates that the economy is pulling back in all the right ways, responding to tighter policy without stepping back from a cliff. What this argument misses, however, is how far more inflation and the labor market should fall—and how painful that fall will be.
Consider first the continuing strength in the country’s services sector. New information released last week showed that growth in the services sector unexpectedly accelerated in November, as consumers continued to resilient spending. It has pushed services activity to a level that, Citi economists said, “raises the prospects of a higher-for-longer price regime again,” given that service inflation is unlikely to slow soon.
The Producer Price Index, released Friday morning, also came in hotter than expected and showed services prices accelerating, even as commodity prices slowed.
With the services sector becoming more active, the proportion of workers who have left their jobs, which had been declining, is now leveling off in the two main service industries that drove many of the major quits, according to one company. Government data analysis by Nick BunkerDirector of Economic Research at Employment Lab Already.
Bunker found that the alleged quit rate in retail has plateaued, while in leisure and hospitality the rate is starting to rise again. This is important because economic research has shown that an increased proportion of workers leaving their jobs can increase pressure on wages, as employers compete to hire and retain employees.
Wages have already started to rise. Average hourly earnings rose 0.6% last month and has accelerated in each of the past three months, dampening hopes arising from declining earnings.
While some analysts brushed aside their worries about rising wages — suggesting much of the increase in November was due to a less alarming drop in hours, rather than a jump in wages — a separate measure released Thursday confirmed earnings continuing to rise: a tracker of wage growth showed The Federal Reserve Bank of Atlanta wages accelerated last month to an annualized growth rate of 6.2% in November from a 6% pace the previous month.
Different ways of measuring profits now “tell a consistent story,” says Jason Furman, a Harvard economist. “No moderation in wage growth.”
For the Fed, rampant wage growth is worrisome because it is fueling inflation in the services sector, where prices continue to rise, even as some other sectors start to see some relief. This forces the central bank to keep interest rates higher for a longer period in an effort to reduce demand.
But there is a second, potentially destabilizing consequence. The higher the wages, Markuska says, the more they slash the profit margins of the small firms that once underpinned the labor market and are responsible for the vast majority of current jobs. She points out that small business owners’ share of wage increases is climbing at the same time that the share that is raising prices is collapsing, according to a recent survey by the National Federation of Independent Business. “The margin space that was created by pricing power and the fact that wages were in arrears — that’s about to reverse,” she says.
Markowska sees small business earnings under pressure in the first quarter of next year, especially as companies make cost-of-living adjustments in January that could push wages higher. This, in turn, can lead companies to withdraw their job openings and lead to a cycle of layoffs, she says. And suddenly, the job market is faltering, even as inflation remains well above target.
Viewed this way, rising wages can undermine the two most important parts of engineering a soft landing: low inflation and a stable job market. The Fed needs both, and rising worker wages could mean the central bank is nowhere near getting either.
All of this indicates that a hard landing and recession are more likely than markets expect. The longer stock investors remain bullish, the more damaging the fallout could be. “This is another mechanism by which a potential recession could deepen, as it makes its way into the markets,” said Larry Summers, former Treasury secretary. Barron.
Summers warns that with an economic slowdown inevitable, in his view, there is a “huge risk” that the Fed will cut interest rates even before inflation falls back to its 2% target. While that could help the economy in the near term, it could also backfire by prompting a second, possibly more damaging, round of interest rate increases shortly thereafter.
The outcome may be similar to former Fed Chairman Paul Volcker’s experience in the early 1980s, when the central bank began cutting interest rates in response to a recession only to raise them again higher when inflation began to level off.
“We’ve all been taught that when a doctor prescribes antibiotics, we’re supposed to take the full course,” Summers says. “But often, people take a course of antibiotics only partially until they feel better, or they feel some side effects, and then they have to go back on the medication.”
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