The Fed Plays Operation
Growing up I loved to play Operation, the children’s board game where players tweeze out ailments from a patient’s body without touching the edge, lest a buzzer sound. It’s a game that requires a steady hand and intense precision. Likewise, the Federal Reserve (Fed) is currently playing doctor on the economy by attempting to tame inflation without buzzing the economy into recession. Unfortunately, the twin commodity shocks of Covid and the war in Ukraine have made the Fed’s task immensely more difficult, and now it’s as though they’re playing their own version of Operation… while driving over potholes. The below examines several “potholes” they will need to navigate.
Oil: Brent is trading at USD120 and nearing the post-invasion highs set in late February. Sanctions have left the global supply chain in disarray with Russian oil trading at a USD35 discount and UAE exports to the EU trading at an USD11 premium. At the moment, there is not enough supply to offset demand. US production is roughly the same as the start of the year, OPEC is 750kbpd (thousand barrels per day) behind its quota, the Iran deal is looking increasingly unlikely, and reserve releases have already been telegraphed. Underwhelming Chinese demand due to Covid lockdowns provided a temporary respite but now appears to be improving. Taken together, the oil market will trade in a deficit, which will keep prices elevated.
Food: In 2010, Russia banned grain exports, and the UN Food and Agriculture index rose 40%; since the war in Ukraine began, it has only risen 16%. With farming and exports limited, coupled with several Asian countries also capping exports, risks are skewed to the upside.
Inflation: Food and energy will remain tailwinds to inflation, even if prices stay steady. That said, if prices trend higher, and we maintain the 6 month average pace of 0.71% MoM, headline inflation could actually hit a new high over 9% in September. On core inflation, the Fed’s preferred measure, there is only limited evidence that supply chain bottlenecks are easing, and while core goods have been declining monthly, prices remain historically elevated on a YoY basis. Shelter and other core services are also moving higher. Despite optimism that we passed the peak, the inflation market is actually pricing a near term acceleration of inflation, followed by only a modest decline in 4Q, signaling the Fed might not see satisfaction until 2023.
Labor market: Despite anecdotes in the tech sector, the labor market remains remarkably strong. Although the pace of job and wage growth has started to decline in recent months, the levels are still high. The 3-month moving average of nonfarm payrolls sits at 400k and the 6-month annualized pace of average hourly earnings is 4.7%, markedly above the pre-covid high of 4%. There remains a 5mm person gap between the number of job openings and the number of unemployed. Barring a drop in payrolls below 100k per month or a large pick up in participation, the unemployment rate will remain around 3.5%, if not lower.
Can the Fed achieve a successful operation? As of today, inflation is historically high and unemployment historically low; looking ahead, however, the situation is more nuanced for two reasons. First, despite a strong labor market, consumer sentiment is at levels not seen since the financial crisis.
This is likely because high inflation is starting to bite. Everyday items such as food and gasoline are rising rapidly (the average gasoline price is approaching USD5/gallon) and savings rates are declining, implying there is less capacity for consumers to weather sustained high prices. In essence, consumers may be fine now, but they are nervous about the future. Second, when the Fed outlined they would use 50bp hikes to move into restrictive territory by 2023, financial conditions tightened materially and recession probabilities shot higher.
So the Fed has signaled they want to expeditiously hike rates to ~2.75% to quell inflation, but the market thinks a recession is likely next year. Here are a few scenarios that could play out:
Inflation is too high, but much of this is out of the Fed’s control; they can’t lower food and energy prices and they don’t control supply chain problems. If achieving their 2% target means overly crimping demand in other areas, enough to offset the rise in food and energy, they might choose to forgo hikes beyond neutral and instead let inflation remain somewhat elevated. As long as inflation expectations remain anchored, this outcome might be amenable.
Food and gasoline are hardly discretionary purchases. If prices remain elevated, consumers will be forced to cut back on other spending, and it's possible demand falls regardless of the Fed's actions. This could lead to a slowdown in core prices, and push the Fed to hike less than the market currently anticipates.
If core inflation remains elevated, the Fed will want to put a dent into wage growth, and it’s possible they are able to hike into restrictive territory without crippling the labor market. If the 5mm person job imbalance is resolved via fewer job openings without layoffs, the unemployment rate can remain stable, allowing them to achieve a healthy deceleration.
While all of the above are possible, it’s not clear they are the most probable. Typically when the labor market begins to weaken, it quickly snowballs. Often what alleviates energy inflation is severe demand destruction. Core inflation might not sequentially decline, forcing the Fed to hike into overly restrictive territory. Or maybe they grow too comfortable with above-target inflation and longer-term expectations move higher, compelling them to act aggressively.
In the end, there might just be too many potholes. Monetary policy is a blunt instrument, not a scalpel, so no matter how steady their hand may be, buzzing the economy into recession might be inevitable.