Another Fed meeting, another installment of What Will the Fed Do Next?

Earlier this month, the Fed hiked their policy rate another 25 basis points to bring the federal funds rate to a target range of 5% to 5.25%. The 10th meeting of this 14-month-long tightening cycle may be the last as we finally reach what the Fed has telegraphed as their terminal rate.

Before we dive into a summary of the FOMC meeting, let’s have a high-level check-in with the economy.

Inflation

Inflation has been stubborn but slowing. While both headline and core CPI are significantly lower from their 2022 highs, they are still running at more than twice their 10-year averages. The same narrative goes for both core and headline PCE, which are running at more than twice the Fed’s target 2% year-over-year pace. On Wednesday, headline and core CPI for April came out at +4.9% and +5.5%, respectively. Core services ex-housing and medical, which the Fed has repeatedly pointed to as dogged, rose only 0.2% month over month, which is well below the 0.7% to 0.9% it has run at in recent months.

The job market

The job market continues to be unpredictably strong. As Powell said on Wednesday, “(The FOMC) has hiked 5% in 14 months and the unemployment rate is lower today than when we started.” The US unemployment rate stands at 3.4% as of April, which is the lowest it’s been since 1969. Furthermore, job openings and labor turnover surveys (JOLTs) show job openings of 9.6mn, which, while down from the post-pandemic peak of 12mn, is still significantly above the pre-pandemic job openings of 7mn. To give you a picture of just how many job openings that is, there are 1.6 jobs for every unemployed person today. As we have noted in past issues, there are a few tides that could shift the tightness of the labor force.

  1. Participation. Labor force participation has been rising slowly in the past 3 years, but still stands historically low at 62.6%, below the pre-pandemic number of 63.4%. If participation can close the gap to its pre-pandemic strength, the labor market should ease which inherently would diminish wage inflation.
  2. Productivity. Higher productivity means a lesser need for additional employees or capacity. The productivity report for the first quarter showed a surprising decline, which ended up driving higher unit labor costs. While concerning, the silver lining could be that businesses are holding on to their employees in hopes for a rejuvenation of demand in the near future. There are also many longer-term tailwinds that could improve productivity over time: automation, AI, machine learning, and so on.
  3. Population. The availability of people to join the workforce is of course a key to our labor supply. As mentioned by Chair Powell, the only factor that can give immediate relief, regarding population, is immigration. Immigration has recently been depressed, but should it be desired by our elected government, is easily shifted by approving more applications.
  4. Labor demand. Of course, on the opposite side of supply is demand. Labor force demand has been incredibly strong but has recently softened as signaled by not only job openings, but general headlines in the past few months as tech-focused firms either continue laying employees off or slowing their pace of hiring.  

GDP growth

GDP growth has recently taken a hit. First quarter GDP growth was +1.1%, which missed the +1.9% estimate and was a meaningful decline from the +2.6% seen in the fourth quarter of last year. This deceleration was largely attributed to a sharp slowdown in the growth of inventory investment. Consumer spending was rather strong at +3.7% which added 2.5 points to GDP growth with notable increases in autos, healthcare, food services, and accommodations. Continued consumer spending strength should necessitate an increase in the rate of inventory investment in the second quarter. On the other hand, capital spending was quite low at +0.9% which bodes poorly for business spending. These statistics are all of course lagging indicators. An arguably more useful indicator is earnings results. As of the end of April, ~50% of S&P 500 companies have reported earnings and 81% have beaten Wall Street estimates for earnings, while 73% have beaten estimates for revenue. This compares to the pre-pandemic trend of high 60s / low 70s for EPS beats. Of course, earnings beats depend entirely on the quality of the estimates they are compared to, but as we saw with the post-pandemic pull forward of demand in certain growthier companies, analysts often fail to incorporate forecasts of bigger-picture macro effects.

So inflation continues to descend slowly, the job market continues to loosen slowly, and GDP and earnings growth continue to soften slowly. Though we would prefer the former to accelerate, the latter two components of the economy moving gradually is welcomed with open arms during any tightening cycle.

Now, back to the Fed.

On the statement release, there was a change in language that was reminiscent of the last hike in the 2006 tightening cycle when the Fed said “in determining the extent to which additional policy firming may be appropriate,” rather than the former, more hawkish language of “some additional policy firming may be appropriate.” This statement change was initially taken as dovish by the market, indicating the Fed’s willingness to consider a pause of rate hikes next meeting.

The press conference and Q&A session proved unsurprising. Again, it may sound reminiscent of past posts, but Chair Powell told us what he was going to do prior. During the March meeting, he hinted at this most recent 25 basis point hike. The inflationary data since March largely met expectations, which cleared the way for Powell to execute on his word. Now he is telling us that the door is open for a pause next meeting, should the data allow. While predicting what the Fed does is fraught with peril, we predict a pause next meeting if 1) inflationary data doesn’t drastically surprise us, and 2) the banking system doesn’t face any further structural tension.

The conversation now shifts from “How high will the Fed go?” to “How long will they stay up there?” Fed projections and commentary tell us that they in no way expect to cut rates for the remainder of this year. The market says otherwise. Interest rate futures imply year-end rates to be around 4.5%, leaving room for 50 bps of cumulative rate cuts. So, the market is telling us something will change somewhat drastically that allows (or forces) the Fed to cut rates. What could that change be? Inflation falling off a cliff, earnings falling more than expected, or unemployment rising sharply. Is the market right? As always, we will watch the various indicators closely and respond to them with the appropriate investment decisions. Stay tuned as we may very well be about to witness the end of what has been a historic tightening cycle.

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