Markets don’t believe Jay Powell

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Good morning. Cheers to Morocco for a remarkable run and for putting up a valiant showing against France yesterday. Unhedged will be watching the finals as we write on Sunday. Send us your World Cup predictions: robert.armstrong and ethan.wu.

The Fed

There was a very brief moment when it looked like the Federal Reserve had managed to deliver a surprise. It wasn’t the 50 basis point rate increase, which was locked in beforehand and was delivered in a statement identical to last month’s. The accompanying economic projections came with a little spice, though: a half-point increase in the outlook for year-end 2023 rates, to 5.1 per cent, even as the projected GDP growth rate was brought down. Of the 19 members on the open market committee, 17 thought that rate should be above five. Back in September, zero did.

The context for this hawkish message was, first, two consecutive CPI inflation reports that had surprised to the downside and, second, a notable loosening of financial conditions — from stock prices to mortgage rates — over the past month or two. Against that backdrop, the message from the central bank was: slow your roll, markets, we ain’t done yet.

Initially, markets flinched. The S&P 500 fell 2 per cent between the release of the statement and the opening minutes of Jay Powell’s news conference half an hour later. The two-year bond, a barometer of policy rate expectations, rose 12 basis points. Not huge moves, but the market was standing to attention, at least.

It didn’t last. As the press conference went on, the market took back losses. The two-year went straight back to sleep, closing the day just about where it started. On Tuesday afternoon, the futures market’s bet was that the policy rate would peak under five, and that the Fed would then make two, 25-basis point rate cuts in the second half of next year. Yesterday afternoon, it was making precisely the same bet.

In other words, the market looked Powell right in the eye and said: we don’t believe you.

Is this a problem? It can only be frustrating for Powell and his colleagues, but if they decide that financial conditions really are too loose, there is a solution at hand: a rate increase. The market’s problem is that it might be wrong, either about what inflation will do or how the Fed will react to it, or both. And if that is so, the only solution is lower asset prices.

Put aside, for now, the question whether the market has a realistic estimate of inflation in 2023 (we think it’s pricing in a pretty optimistic scenario, but inflation forecasting is very hard). Focus, instead, on the market’s implied view of what the Fed will have to do to get inflation down, and the central bank’s own view.

As already stated, the futures market expects the Fed to start easing policy in the second half of next year. Bond markets expect inflation to come down fast. Near-term break-even inflation is at 2.3 per cent and falling:

There is one perfectly plausible scenario under which inflation would fall fast and the Fed would cut rates: a recession. But markets are not expecting a recession. The price/earnings ratio on the S&P 500 is back to its pre-pandemic level, that is, historically quite middling:

Line chart of S&P 500 forward price/earnings ratio showing No recession here

Junk bond spreads are not recessionary either. Here’s triple-Cs:

Line chart of CCC corporate bond spreads over Treasuries, % showing Wider but not wide

What the market sees coming, in other words, is the Fed cutting rates next year because inflation falls quickly without help from a serious economic contraction.

The contrast with Powell’s view is stark. Yesterday he restated his tripartite inflation framework, rolled out last month: goods, shelter, and non-shelter core services. He emphasised that the Fed’s decisive battle will be in the last category. Crucially, he believes these prices are tightly linked to the labour market. The problem, in Powell’s words, is that “it feels like we have a structural labour shortage out there”, which he pinned on accelerated retirements, Covid-19 deaths and a drop in migration.

He hearkened back to a chart he showed last month, showing the labour supply 3.5mn workers short of demand:

Chart of jobs and workers

He also alluded to anecdata, such as that collected in the Fed’s Beige Book, suggesting employers remain desperate for workers, even in the face of a slowdown. A recent selection:

[From the Philly Fed:] Firms from many sectors reported preparations for a potential recession but also remain hesitant to lay off employees, given recent hiring difficulties

[Atlanta Fed:] Finding qualified candidates was reported as nearly impossible, so firms increased investments in training new hires

[Richmond Fed:] The supply of labour remained tight with several contacts noting difficulties finding workers with necessary skills. One company that was looking to hire an experienced worker decided to hire an entry-level worker instead and pay for their training.

The Fed, in sum, is worried about a category of inflation that won’t fall until labour market conditions get worse for workers, which they are a very long way from doing. And since labour supply probably won’t expand suddenly (Congress does not seem keen on tons more immigration), labour demand will have to fall.

The market view that inflation glides down, rates get cut and the US sidesteps a recession looks inconsistent with Powell’s view of the economy. In his framework, for the labour supply-demand gap to close, rates have to weigh on demand — meaning higher rates for longer. The world where the Fed, highly attuned to loosening policy too soon, starts cutting is a world where the economy is entering recession.

Maybe the market has figured out something Powell hasn’t, like inflation’s fall being much faster than its rise. At a minimum, they are clearly operating with different reaction functions. But remember: the Fed chair has the power here. He who holds the policy levers has more sway over markets than they do over him. That markets disagree with Powell’s outlook is fine, but it is ultimately a gamble. If he presses on, investors will get stuck holding the bag. (Armstrong & Wu)

One good read

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