What Will the Fed Do Next?

Earlier last week, the Federal Reserve unanimously raised their policy rate 25 basis points to make the high end of the policy range 5.50% – the highest it’s been since early 2001. The 11^th hike in the past 17 months comes two weeks after a softer than expected CPI report instilled hope that the Fed may not have to reach their terminal rate to achieve their 2% inflation target.

The statement release was rather unsurprising. It contained a mashup of language we have seen in months prior. “In determining the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time…” left the door open for further rate hikes and confirmed that the Fed’s 2% inflation target will remain unchanged.

Afraid of commitment?

When Powell took the stage, reporters tried to hit him from every angle, desperate to get a hint of what the next meeting might have in store. Powell didn’t budge. In fact, he muddied the already opaque water saying, “It is certainly possible that we will raise rates again at the September meeting…and I would also say it’s possible we would choose to hold steady at that meeting.” Powell went on to echo phrases he has been saying for months.

We will go meeting by meeting.”

“It will take time for the full effects of tightening to be felt.”

If there was anything that came as a surprise, it was when Powell noted that the Fed staff economists, who create their own independent economic projections, are no longer predicting a mild recession. While these projections don’t reflect the thoughts of the policymakers, there is something to be said about the “wisdom of the crowd.”

Time for the usual check-up…

Economy

A movie about Barbie is smashing box office records. Taylor Swift tickets are selling for tens of thousands of dollars. Travelers stopping over at the illustrious LaGuardia Airport are paying at least $200/night to stay at a two-star hotel. Las Vegas average room rates are still historically high. These clearly aren’t signs of impending doom in discretionary spending. In fact, just last week, the second quarter annualized GDP number came out at 2.4%, which easily topped the 1.8% expectation. Capital spending was the most important contributor to the strong quarter, growing 7.7% and adding 1.1 points to second quarter growth. In an encouraging sign of continued disinflation, the price deflator in the GDP calculation declined to 2.2% from 4.1% in the first quarter. Alas, as Powell pointed out, unexpectedly high economic growth in a tightening cycle does not help reduce inflation…and it often leaves room for more tightening.

Inflation

June core PCE inflation was up 0.2%, in line with estimates, but lower than the +0.3% in May. Year over year core PCE inflation is now 4.1%, the lowest level seen since September of 2021 and a sharp improvement from the 4.6% in May. June CPI and core CPI came in below expectations at +3.0% and +4.8% year over year, respectively. Core CPI breaking below 5% can be viewed as a major milestone, but it is often the “last mile” of getting inflation to the Fed’s 2% goal that proves the most difficult. On a year over year basis, services inflation, which the Fed has under a spotlight, stands at +6.2%. On the goods side, there are growing signs of deflation as consumer durable prices are now down 0.8% year over year in what appears to be a recessionary environment for the manufacturing sector. Other aspects of inflation, like rental costs, are expected to continue to decline given their inherent lag.

Job Market

Weekly jobless claims remain historically low with last weeks reading coming in at 221k, slightly off the 237k in the week prior. The unemployment rate stands at 3.6% – exactly where it was when the tightening cycle began in March of last year. June job openings came in at 9.58M, which was a small 0.4% sequential drop. The second quarter employment cost index was up only 1.0%, which was below the 1.1% estimate and the 1.2% from the first quarter which entails some progress on wage inflation. Wages have come into Powell’s spotlight as of late. Sharp hourly wage gains can perpetuate inflation if employers are forced to raise prices on their customers to offset the higher costs. Nonetheless, there can be tightening cycles without deep recessions, but there really can’t be deep recessions without a stressed labor market. While low unemployment has its own consequences, like inflation and reduced marginal productivity, it also very simply means able people are making money, which is of course a necessary defense against recessionary backdrops.

Too soon for a victory speech…

Aside from one softer than expected inflation report, it has largely been “steady as she goes” since the last FOMC meeting. Earnings have gone smoothly for the majority of S&P 500 companies, negative employment headlines have calmed down, and the regional banking system has so far skirted a major crisis. Does that mean the soft-landing scenario looks more likely? Not exactly. Many past recessions have been preceded by seemingly positive economic news and data. For example, the downturns in 1990, 2000, and 2007 all came right as consensus shifted towards a soft landing.

If you were to plot the fed funds rate against the unemployment rate over time, you would see that in most recessions, the fed pivots right as the unemployment rate begins creeping up. That fed pivot then becomes a hasty rate cutting cycle as unemployment dramatically accelerates. We have yet to see any real damage in the unemployment rate. This isn’t to say we are barreling towards a recession if we do – after all, there have also been tightening cycles that have turned to rate cutting cycles without significant damage to the labor market. For example, in 1994 and 1995, the Fed was able to successfully cool off a hot economy while escaping an economic downturn. And guess what? People generally didn’t think the Fed would be able to pull it off.

Powell has constantly reiterated, “Effects of monetary tightening has long and variable lags.” It’s no surprise Powell didn’t want to give a hint on what the Fed might do next…because, collectively, even they have no idea. The data that comes out between now and the next meeting will be essential to their ultimate decision. All they know right now is the economy is performing better than expected, the labor market is stronger than they would like it to be, and the last mile to get to 2% inflation is the most difficult. But they don’t know what effects this historic tightening cycle will have as time goes on. There are two more CPI reports, two more payroll reports, and a slew of more earnings reports to come before the Fed meets in September. So of course, Powell wants to keep his options open for next meeting. If history has taught us anything, it’s that just because a soft landing looks likely, doesn’t mean it’s going to happen. Likewise, just because people are doubting the Fed’s actions, doesn’t mean the Fed isn’t doing what is right. As frightening as it can be to look back on history sometimes, it is essential to ensure we don’t repeat our own mistakes. As legendary investor Howard Marks says,

“One of the important factors behind the fluctuation between bull and bear markets, between booms and crashes and bubbles, is that investor memory has to fail us – and fail universally – in order for the extremes to be reached.”

So what will the Fed do next? They will react to the economic data to come. The nearest material economic data to be released is the labor report on Friday where we will see July updates for the unemployment rate, hourly earnings, and labor force participation- three numbers that are squarely in the spotlight right now.