The Fed’s Less Than Desirable Outcome

 

The month of August was looking reasonable – we saw an extremely strong employment report and encouragingly soft inflation data. Powell’s Jackson Hole speech was short and sweet but also clear and concise. The remaining Fed members rallied around a hawkish tone that was generally well communicated and accepted in the market. Enter in the month of September…. while off to a good start with the employment report and ISM surveys, the consumer price report took the wind right out of the Fed’s sails. There is very little debate in the market in the wake of the higher-than-expected report that a 75bps hike is all but set for the September meeting. Acknowledging that Monetary Policy works with a lag, the Fed is still likely disappointed with the transmission mechanism, and we believe they will continue to aggressively hike rates in an attempt to slow demand.

Early Stage prices and Inflation Expectations turned over, Core CPI continues to Lag:

• Oil has been on a downward trend since June bringing relief to the pump with national average gasoline prices back below $4/gallon.
• ISM Manufacturing Prices Paid moved down to 52.5 from a high of 92 while the Producer Price Index marked a slower pace of increase YoY in the August data.
• Inflation expectations continue to decline after peaking in the first half of 2022.
• The Consumer Price Index shocked the market once again in the August report with the data unfortunately higher-than-expected. The headline rose 0.1% and softened to 8.3% YoY from 8.5% in July and a high print at 9.1% YoY in June. The headline is moving in the right direction, but the progress is slower than the market hoped. Core, on the other hand, caught the market off-guard, rising 0.6% this month to 6.3% YoY vs. 5.9% in July.

 

Oil vs. Gasoline

 Source: Bloomberg, 9/13/2022

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ISM Manufacturing Prices Paid vs. PPI Ex Food/Energy/Trade YoY

Source: Bloomberg, 9/14/2022

 

University of Michigan Inflation Expectations 1-yr Ahead

Source: Bloomberg, 9/13/2022

Consumer Price Index vs. Core CPI

Source: Bloomberg, 9/13/2022

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What’s Next?

• The next Fed Rate decision is Wednesday, September 21. We expect to see a 75bps hike as well as a fresh round of economic projections and hear from Powell during the press conference.
• Post the September decision, we have two more Fed meetings this year, in November and December. The market is currently pricing a Fed Funds Rate between 4-4.25% by year-end with a terminal rate at 4.38%.
• We are watching the beginning stages of the supply chain and listening to company commentary to garner real-time information around changing inflation and growth trends.
• Powell clearly stated: “The Federal Open Market Committee’s (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal. Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labor market conditions that benefit all. The burdens of high inflation fall heaviest on those who are least able to bear them…. We are taking forceful and rapid steps to moderate demand so that it comes into better alignment with supply, and to keep inflation expectations anchored. We will keep at it until we are confident the job is done.”
• While the Fed has been laser focused on using traditional rate policy (raising Fed Funds) to fight inflation, we question if/when the Fed will consider using its more powerful tool, the balance sheet, to send a stronger message to markets around their inflation fighting commitment. A change in the Fed’s position on the balance sheet reduction could bring another layer of volatility into markets where yield curve inversions are significant – 10yr U.S. Treasury minus 2yr U.S. Treasury currently sits at -37bps.

 

 

U.S. Interest Rate Probability

Source: World Interest Rate Probability, Bloomberg, 9/14/2022

 

The Fed’s fight to bring inflation back to the 2% target is not over yet, and the mechanism to do so will continue to bring unintended market and economic consequences. Powell did not mince words when he stated “While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”

We are reminded daily of a simple but profound phrase, “Don’t Fight the Fed”.

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