It’s Playoff Season for the Fed
As a hockey fan, I love the month of April since it signifies the start of the National Hockey League (NHL) playoffs. Every coach’s decision will be scrutinized, every goal will be amplified, and every mistake will be magnified. While the regular season is important, what ultimately matters is which team lifts the Stanley Cup. Like most hockey teams, the Federal Reserve (Fed) had some hiccups of their own during the regular season. They were late to begin hiking and the speed of their hikes contributed to the recent stress in the regional banking system (though their swift response staunched the bleeding). Nevertheless, we can’t deny that they have made significant progress on their goals. They have hiked rates nearly 500 basis points (bps), CPI has cooled from 9% year-over-year (YoY) to 5%, and inflation expectations are contained, all while the labor market remains resilient.
But just like in hockey’s postseason, now that we are in the endgame of the hiking cycle, the stakes are raised; policy decisions have greater ramifications, the odds of a misstep increase, and new questions arise, particularly given the long and variable lags of policy. How will the Fed know when to stop tightening policy, and when will they begin easing? Will they miscalculate and crash the economy, or will they glide the economy back into equilibrium? With some helpful illustrations from my colleagues Dave Rooney and Kelsey Berro, I make the case for why the Fed should consider pausing now.
Optically, inflation looks sticky with Core CPI YoY increasing by 0.10% in March to 5.6%, still well above the Fed’s 2% target. However, by digging into the details, a different picture emerges. First, shelter may finally be starting to cool, with Owners’ Equivalent Rent falling to 0.48% month-over-month (MoM) in March vs. 0.70% in February. Real-time housing indicators such as Zillow and Apartment List suggest shelter should continue to normalize toward ~0.30% MoM by the end of the year. Second, while the Fed is rightly focused on core services ex-shelter, the broader trend has been downward as the 6mo annualized number has declined from a high of 8% last June to 3.7% this March. Furthermore, survey measures of supply chain pressures in this area have been plunging. If we map the Supplier Deliveries subcomponent of the ISM Services report to Core CPI YoY, it implies we could see a meaningful decline in inflation over the course of the year.
Finally, numerous measures of inflation expectations, such as the UMich survey, the Philly Fed Survey of Professional Forecasters, and 5y5y CPI swaps have either remained stable or declined from the highs. Indeed, our own analysis of the Fed’s purported favorite metric, the Common Inflation Expectation (CIE) index, which aggregates these measures, points to further declines:
2) Labor Market
Like inflation, the labor market looks tight in real-time. The 3-month moving average of Non-Farm Payrolls (NFP) is 345k, and the unemployment rate is 3.5%. However, the last three prints show a meaningful decline from 472k new jobs to 236k, while the labor force participation rate has increased four consecutive months back toward the lower end of the pre-covid range. Furthermore, wages continue to show signs of moderation. The 3mo and 6mo annualized paces of Average Hourly Earnings (AHE) have declined materially, with the 3mo number for all workers falling to 3.20%, a level the Fed would view as consistent with 2% inflation:
In addition, forward-looking survey measures suggest the labor market will continue to soften over the course of the year. For example, the NFIB Small Business Hiring Plans Index is now at the lowest level since Covid and has recently diverged from the employment data.
3) Credit Conditions
At the March FOMC meeting, Chair Powell introduced a new factor in determining whether to hike rates: credit conditions. Specifically, he said that in the wake of SVB, there will likely be “some tightening credit conditions for households and businesses…[which] would work in the same direction as rate tightening.” Many measures, such as the Senior Loan Officer Opinion Survey and the NFIB Small Business Credit Conditions Index (pictured below), had shown deterioration in loan availability even before the banking crisis, and this will only be exacerbated going forward.
The Fed is monitoring credit conditions for good reason. Tighter financial conditions will hamper businesses’ ability to invest, which can in turn lead to less hiring, reduced pricing power, and ultimately recession. The Conference Board surveys consumers to see whether they judge jobs as becoming easier or harder to get (i.e., the Labor Differential). This plots well against NFIB Small Business Expected Credit Conditions and implies as credit conditions tighten, it will become more difficult to find a job.
Wayne Gretzky once said: “Skate to where the puck is going to be, not where it has been.” If the Fed only uses spot data, which admittedly paints a picture of a resilient labor market and elevated CPI, they run the risk of overtightening and pushing the economy into a deeper recession. They remain rightfully wary of sticky inflation, but there is now a plethora of forward-looking survey measures, which suggest the economy is weaker than it appears. In other words, while data dependency has been the Fed’s guiding principle throughout the hiking cycle, they need to now be cognizant of the lagged effects of their prior actions and heed the hockey hall-of-famer’s advice: when making monetary policy decisions, incorporate where the economy is going to be, not where it has been. Right now, the market’s base case is for a hike in May, but beyond that, the bar should be exceptionally high for the Fed to go further. If this holds true, both the NHL Playoffs and the tightening cycle will be over by June, so plan accordingly.