The Fed’s High-Wire Act Is Almost Over

05.03.2023 Federal Reserve policymakers are meeting today to weigh what is widely expected to be their tenth interest rate hike since March 2022. Challenged by persistent inflation and a robust economy, Powell & Company embarked on what turned out to be the most aggressive tightening program since 1980.  Monetary authorities hope to tame inflation without killing the economy, arguably a financial high-wire act. But will they go too far?

Recent US Hiking Cycles chart

US inflation has decelerated over the last 12 months, but at five per cent year over year it remains stubbornly high by historical standards. While energy prices are 6.4 per cent lower than they were 12 months ago, which corresponds to the outbreak of Russian hostilities, food prices are 8.5 per cent more expensive. Consistent with reopening, services, an area crimped by global lockdowns, cost 8.5 per cent more than they did last year at this time. The Fed will be looking for clear evidence that inflation pressures are abating before shifting to neutral.

CPI YoY History chart

Q1 GDP rose a modest 1.1 per cent on an annualized basis, with consumer spending representing the biggest contributor to growth. Since emerging from a two-year lockdown, Americans have wanted to have fun. Households spent heavily on automobiles and recreational goods and vehicles, like boats and RVs. Spending on recreational services rose at an annualized rate of 5.9 per cent in the first quarter. Consumer companies, like Coke, Pepsi, McDonalds and GM, were able to pass along quarter-on-quarter price increases without much pushback from their customers. Indomitable consumer demand stems from the strong labor market where, despite recent layoff announcements, job opportunities abound. Unemployment is just 3.5 per cent, wages are strong and workers are emboldened. Hollywood is bracing for a writers’ strike, while pilots at American and Southwest threaten work stoppages. Policymakers would need to see labor conditions ease before easing monetary conditions.

Unemployment vs Average Hourly Earnings (YoY) 2006-Present chart

Businesses, meanwhile, are not as sanguine. The business sector accumulated inventory in Q4/22 because it overestimated demand. In Q1/23, inventory drawdown was the biggest detractor from growth, knocking it down by 2.3 percentage points. Business investment in plant, property and equipment has sagged, reflecting management caution. According to the National Federation of Independent Businesses (NFIB), small business optimism has fallen to a level below that seen during the pandemic.

NFIB Business Optimisim Index (with recessions) chart

Interest rate sensitive housing was the first segment to feel the effects of Fed policy. The 30-year mortgage rate, at 6.9%, is nearly three percentage points higher than it was at the beginning of 2022. All told, housing ‒ including all the industries it touches ‒ represents 10 per cent of the domestic economy.  For now, home values have remained intact, despite higher financing costs. Housing activity, however, has collapsed: the number of building permits issued has plunged by 25 per cent from its peak. Sales of existing homes have declined by 30 per cent since the beginning of last year, as would-be sellers are sitting tight, understanding that moving would force them to finance their new purchase at a substantially higher rate.

Building Permits (OOOs) chart

Our developed-market trading partners are facing similar economic challenges. The European Central Bank, is grappling like the Fed with stubborn inflation. Europe has been remarkably resilient in the face of Russia’s war on its doorstep, banking turmoil and higher interest rates. According to EU statistics, the combined output of its 20 constituent countries rose at an annualized 0.3% in the first quarter, reversing the contraction felt in Q4/22. The region’s stronger-than-expected growth came on the back of warmer weather and lower energy prices. The price of Russian natural gas sank in large part due to imports of liquified natural gas from the US and elsewhere, according to The Wall Street Journal.

US vs EU GDP Growth (YoY) chart

Bottom Line: We expect the Fed will raise rates to 5.0% and hold, allowing the lagged effect of monetary policy to gain traction. History has shown that the impact of higher overnight rates can take between one and three years to affect the labor market. We’re confident policy makers are aware of that relationship. If they were to continue to tighten until they see tangible evidence of their efforts, they would kill the economy in their quest to quell inflation.

Unemployment vs Fed Funds Rate chart
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