Elusive Pivot

Our problem is not the Fed. The problem is the persistence of inflation. On Wednesday of this week the Fed raised the target rate by the expected 75 basis points. The statement came with an acknowledgment to markets that the FOMC is well aware of the lagged manifestations of the policy action taken thus far and the market celebrated as traders sniffed what they thought could finally be the pause. Once Chairman Powell started answering reporter’s questions, the celebration came to an abrupt and painful end as he made clear that it remains premature to consider an end to the current hiking cycle. Stocks reversed lower, the dollar moved higher, and bonds sank all along the curve.

None of that is to say the Fed has done a good job in combating inflation. Not only did they start the tightening cycle too late but they were still buying mortgage backed securities when the housing market was pressing into bubble territory. But all of that is now water under the bridge. The Fed is now doing exactly what they should be doing. They recognized they were woefully behind the curve and in a short period of time, they have raised rates by 375 basis points and have guided the market to expect a terminal rate in the neighborhood of 5%. Considering Core PCE price inflation is still running over 5%, that doesn’t strike me as a punitive policy position.

All of those who were expecting a pivot should consider how realistic that expectation was given how little progress has been made on the key underlying driver of inflation which is wage growth. The Atlanta Fed Wage growth tracker is still running at 6.5% nominal growth. Third quarter unit labor costs rose by 6.1%. To put that in perspective, our friend Peter Boockvar notes that in the 20 years preceding the pandemic, unit labor costs grew at an average rate of 1.3%. The JOLTS job openings series, after ticking down last month actually ticked up again in October. Weekly jobless claims continue to bounce along historic lows at around 218,000. In other words, I know and Powell knows that employment is a lagging indicator, but it is unreasonable to expect the Fed to talk about a pause when they have seen such little progress on the labor front.

Consider for a moment a scenario where the equity bulls got their wish yesterday and the Fed came out and said: we’ve tightened a lot, we know the economy is weakening so we are going to take a pause and watch. I’m sure stocks would have screamed higher for the remainder of the session, but what about after that? What if the next couple CPI and PCE readings run hot? What if wage pressures continue unabated? My guess is that you would see a rapid bear-steepening along the curve. In other words, rates on longer duration bonds would move higher driving mortgage rates up significantly and the Fed would be in the position of resuming hikes and fighting to re-establish credibility.

Over a longer time horizon, whether the Fed gets it about rights or overtightens by 100bps, isn’t important. What is important is why has this inflationary cycle been so resilient? Why has employment and wage growth stayed so strong when leading indicators are falling deeper into contraction territory? Clearly demand remains too strong as the excess fiscal stimulus makes its way through the economy. But the answer, at least in part, is also the worker shortage of which the causes are secular. Employers who have worked so hard to attract and retain workers over the last 12 months are loathe to consider layoffs. I have no doubt that employment will weaken cyclically and the Fed will bring inflation down in the near term but the secular pressure on wages will not be eviscerated.

The list of causes for the worker shortage is a long one: aging demographics, deglobalization, falling productivity growth, declining legal immigration, declining male labor force participation, and finally, long covid.

Over time, I’m sure there will be myriad innovations that drive higher productivity again, and hopefully public policy will change toward immigration, but overall if you consider the confluence of all the factors enumerated above, it is hard to make a case that wage pressures will not remain problematic well beyond the current cycle. Now is not the time to try to pick bottoms in stocks or incur more risk.

For more from Tim, follow his podcast The Weekly Bull and Bear wherever you listen to your podcast or read his weekly blog posts here.

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