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February 11, 2023
As expected, the Fed hiked rates 25 basis points this past week, marking a stepdown from December’s 50 basis point hike and 4 prior 75 basis point hikes. As has been the case for the past year, the market was laser-focused on the press conference that followed. While Fed Chairman Powell maintained a hawkish tone, he was sure to convey that while the job is not yet done, we are beginning to see signs of disinflation. “Disinflation” became a word that the market reacted increasingly more positive to each of the 13 times it was spoken.
As I try to do with every written piece, the goal of this series is to teach the reader something that better helps them understand the more sophisticated commentary they may see from other members of our investment office. In this tertiary installment of “What Will the Fed Do?” I’m going to lay out what I see as the Fed’s checklist on the flight plan to fighting inflation- something Powell articulated quite well in this past press conference.
PCE, also known as consumer spending, is a leading economic indicator calculated by the US Bureau of Economic Analysis. It measures the spending on goods and services by people in the US whether it be on shelter, airplane tickets, your child’s school lunch, or even gambling. The Fed focuses on Core PCE, which strips out food and energy prices due to their inherent volatile pricing, which isn’t always a direct result of inflation. Both the Core PCE and the more volatile CPI (Consumer Price Index) have displayed indications of disinflation since last summer with headline CPI peaking in June and Core PCE peaking in February after repeatedly surprising to the upside in the three months prior.
So, we know what PCE is, and we know how it’s been trending. Now let’s look under the hood. Core PCE can be summarized in many ways, but the Fed looks at it as roughly ¼ goods, ¼ housing, and ½ core services excluding housing.
Inflation on goods has begun to cool and is expected to continue trending downwards.
Housing inflation is expected to begin cooling as the Fed’s recent rate hikes work their way through housing prices and into rental pricing. As interest rates rise, so do mortgage rates. As mortgage rates rise, housing prices need to fall as potential buyers will have less money to pay for homes given their more expensive mortgages. Eventually, this domino effect works its way into an obscurely calculated number called “owner’s equivalent rent,” which essentially shows what rate landlords are willing to rent their properties out at.
Unsurprisingly, core services ex-housing has been the more stubborn of the three components to Core PCE. There is a constant ebb and flow between goods and services demand as the typical consumer will often spend the same amount of their paycheck week to week but will shift that amount spent to where they see more value. As goods prices rose last year, services looked more attractive – so people stopped ordering their Amazon packages and took the family on that trip to Disneyland they had been pushing back because of lockdowns. What we’re running into now is the inherent stickiness of services inflation.
What needs to change for the Fed to get closer to declaring victory? Goods inflation needs to continue falling, the housing sector needs to show a convincing disinflationary trend, and services inflation needs to follow suit. The Fed has been clear they want to return to their 2% target inflation rate, which cannot happen without all three components of PCE following the Fed’s expectations.
The morning of the Fed rate decision, the Job Openings and Labor Turnover Survey (JOLTS) showed 11 million job openings at the end of December against the expected 10 million. Two days after the Fed hiked rates, an increase of 517,000 nonfarm payrolls were announced against the expected 189,000. Both numbers indicate the Fed will continue to have room to raise rates without causing unemployment to spike- If they do is another question. There has been a lot of debate over lagged effects of rate hikes and if the Fed should pause to let those effects play out. The Fed seems to believe they have room for another total 50 basis points in hikes. This is where fears over entrenched inflation clash with not only fears over people losing their jobs, but fears of the overall economy entering a recession. It all comes down to finding out how much is too much, too fast. It is our belief that the Fed will soon pause to allow these higher rates to work their way through the economy. A pause, coupled with a strong initial backstop of low unemployment, should be sufficient to come to a softer than expected landing. The best-case scenario looks to be for JOLTS to begin showing lower job openings, unemployment to slowly inch higher, and labor force participation & productivity to continue increasing. The latter proved out last week with labor force participation increasing to 62.4% and nonfarm productivity increasing 3.0% versus an expected 2.4%. To sum everything up in an aviatic metaphor (because everything related to the Fed seems to be an aviatic or avian metaphor), we can see the lights outlining the runway, but we’re still fighting through gale force winds.
The Fed watches a slew of economic indicators in order to make their forecast for GDP growth. Many of those indicators can be derived or are themselves derivations of earnings results and forecasts. Right now, we are in the midst of a very carefully examined earnings season, where almost every company in the S&P 500 and beyond is reporting their quarterly results and forecasting their next quarter or year. Unsurprisingly, there have been abundant words of caution pointed towards the Fed from more cyclically exposed companies, while more defensive companies have touted the levers they can pull in economic downturns. Many of these earnings calls sound quite chilling and could convince the average listener that a recession is inevitable, but funny enough, that in and of itself is an argument for why we might not be barreling towards a recession – people are expecting it. When you expect a hurricane, do you leave your car outside with the windows open? Do you skip your trip to the grocery store the week before? No. You park the car in the garage, and you buy a couple extra loaves of bread (or apparently, rolls of toilet paper). That’s what we are seeing these companies doing. They are preparing for something worse than what we will likely experience. Companies with exposed balance sheets are cutting costs, laying people off, and becoming leaner. Companies with healthy balance sheets are turning their straw houses into brick houses – they’re going on the offensive and spending to gain market share. When everyone expects something horrible to happen, it often doesn’t end up happening, or if it does, it was so well telegraphed that it didn’t end up being quite as bad as expected.
The runway is visible. On the left we have spiking unemployment, earnings falling off a cliff, and accelerating disinflation. On the right we have rising job openings, a stubborn labor force, and entrenched inflation. All the Fed needs to do is put our front wheel down on the white dotted line.
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Sawyer is a Senior Associate in our Boston office where he serves as a research analyst conducting due diligence, security selection, and trading for firm's...
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