After posting the strongest ISM services report on record, the highest ISM manufacturing report since 1983, and 916k jobs created in March, some have compared the recent economic recovery to a sugar high. Inspired by the recent Easter holiday as an analogy, it appears that the Federal Reserve (Fed) has been on an egg hunt of their own since last March, searching for signs of an economic recovery and in the process has collected a large number of colorfully wrapped economic treats. Just as the adults in each household know when to stop eating the leftover Easter chocolates and simply throw them out, is it reasonable to think that the Fed must be a similar voice of reason? Chair Powell needs to determine when the labor market and inflation have achieved “substantial further progress.” Put another way, what needs to transpire, and how long will it take for the Fed to judge that the economy has achieved enough progress to start normalizing policy? Identifying the point of “substantial further progress” is important because this is when the Fed will begin to provide the green light towards tapering their asset purchases, and will ultimately be the first step on the Fed’s journey towards rate hikes.
It all rolls up to the following question: Will record fiscal and monetary support give the markets a massive belly ache via runaway inflation, or will strong job growth and improved production capacity create sustainable growth momentum? The difference between these two outcomes has profound implications for monetary policy, the length of the cycle, and the shape of the yield curve. As it stands today, the market thinks a belly ache is more likely, while the Fed is expecting a soft landing. The market is currently pricing in nearly a full rate hike by the end of 2022, coupled with 5-year inflation breakevens at their highest level since 2008 (and 30 bps higher than 10-year breakevens). This is indicative of an overheating economy and expectations for a near-term inflation overshoot that will require a meaningful hiking cycle. Looking beyond the first rate hike, the market is also expecting an economic recovery that will ultimately require nearly 10 rate hikes from late 2022 through 2030, which would get the funds rate close to the Fed’s 2.5% estimate of the long run dot. On the other hand, the median of the Federal Open Market Committee (FOMC) is still predicting no rate hikes through 2023 and very little pressure on core PCE above 2%, despite above trend growth and a rapidly falling unemployment rate.
If the market and the Fed both fully understand the Fed’s monetary policy reaction function, the divergence in outlooks for the Fed’s future policy path must be attributed to expectations on the economic data. Below are two aspects of the data we are watching that may be underappreciated:
1) The pace at which we fill the 8.4 million jobs gap versus structural shifts in the economy
As a result of the COVID-19 crisis, we lost an astonishing 22 million jobs in just two months at the start of 2020, but since then have recovered 62% without a fully re-opened economy. Expectations are for the pace of hiring to accelerate even further, but one also has to question how much “low hanging fruit” is left in the labor market. This depends on your view of how much the economy has changed since the pandemic started.
For example, the leisure and hospitality sector created 280k jobs last month. If gains continue at this pace, it would take another 11 months to recover all the lost jobs in the sector, but it could also take even less time than that. The pace of hiring may quicken even further as we approach the warmer summer months and when a higher percentage of the population is vaccinated.
In sectors less directly impacted by COVID, however, what job functions have businesses learned to live without? In addition, could there still be scars forming in the labor market as the economy recovers? Let’s examine business and professional services, which remains 685k jobs short of pre-COVID levels. Even if strong demand ultimately results in more hiring, will businesses drag their feet and invest in CapEx over labor to meet increasing orders? Under this scenario, we may realize that a focus on CapEx investment and productivity enhancements to meet growing aggregate demand does not strain capacity or stoke runaway inflation.
2) The interplay between commodity prices, core inflation, and inflation expectations
You’ve probably heard the tale of inflation “base effects” many times already so we won’t bore you by going there. The Fed has been quick to blame easy comps for flattering the annual pace of inflation, suggesting it does not see these inflation pressures as persistent. The market, on the other hand is not fully sold on the transitory explanation given the magnitude of fiscal and monetary stimulus, coupled with pent up demand and excess savings.
Just like we recommend you “look through the base effects,” you have also probably heard the Fed say that they look through large movements in food and energy prices. This is why they prefer core measures of inflation as better predictors of the future. Today, the Bloomberg Commodities index is up 33% versus a year ago. As a result, headline inflation is likely to surge far ahead of core in the coming months. In fact, we anticipate around 2.25% on core CPI but over 3% on headline. While this upcoming surge in headline over core is fairly known to those who watch inflation closely, we think that the impact of rising commodity prices may temporarily distort other measures of inflation that market participants point to as evidence that the structurally low inflation story is shifting.
We believe it is too soon to know, either way, if we are turning the corner and moving towards fundamentally higher inflation. Nevertheless, what we do know is that data series such as the “Prices Paid” subcomponent within the ISM Manufacturing report have historically correlated much more closely with headline inflation and commodities than core inflation. Similarly, measures like the 5y5y forward measure of inflation expectations generated from the Michigan consumer survey tend to shift with gasoline prices even though theory would suggest that they should not. So while these series could be signaling the start of a meaningful shift, they could also end up being a false alarm in the near term by being stealthily influenced by energy prices.
This underappreciated commodity impact is especially important because the Fed’s newly created measure of inflation expectations called the Common Inflation Expectations index (CIE) includes a number of inputs that could be temporarily influenced by the move in gasoline (up nearly 50% over the past year). These include series derived from the UMich survey (as discussed above) as well as the Conference Board survey. Ultimately, we take some comfort in the fact that 5y5y inflation swaps remain ~60 bps below levels observed between 2010 and 2013.
The market seems eager to keep the sugar rush going while the Fed will need to watch for cavities. At the moment, they are both able to operate in harmony, despite diverging views on the Fed’s policy path, because financial conditions have remained extraordinarily easy and neither side has enough data to demonstrate their view is unequivocally correct. If the market is ultimately proven right, however, and the economy and inflation overheats more persistently, we risk upsetting this equilibrium and may be in store for a painful belly ache.