In the week just past, there were several meaningful developments that helped to contribute to the markets’ broader understanding of the macro landscape.
A Dovish Taper
Most notably was the FOMCs decision to follow through with a tapering announcement. The announcement delivered was extremely well-telegraphed, widely anticipated and precisely what the market was looking for, which was 15 billion a month of tapering, 10 billion in Treasuries, and 5 billion in mortgages. This puts the presumed end of QE in the middle of 2022. That’s been a very well-telegraphed timeline. And as a result, the price action which ultimately occurred was relatively limited. And by characterizing it as a dovish taper, I simply mean that the Fed chose to emphasize that, while the threshold for winding down QE has been achieved on the employment front, the same cannot be said about the threshold for rate hikes.
At this point in the cycle, while market participants might think that policy makers are behind the curve, but unlike forcing a central bank to ease, it is very difficult to force a central bank to tighten monetary policy. In fact, it may look like that the market was pricing in a significantly higher probability of rate hikes in the near to medium term, but in practical terms, effectively what has occurred is that the market is tightening for the Fed, which is entirely different than the market prompting the Fed to tighten. In fact, as front-end yields increased, we saw equities begin to wobble and financial conditions tighten, which is the opposite of the type of environment in which one would expect hawkish action from the Fed.
Supply-driven Inflation？
We also heard from Powell at the press conference that at this point the acceleration in consumer prices is probably still more a function of issues on the supply side. There will eventually come a time when the logistical headaches and supply chain bottlenecks work themselves out. And until then the Fed will have greater clarity on this topic that the committee will start contemplating raising rates.
So the question becomes, how high is the risk that the Fed is either in the midst of committing a policy error, or will eventually commit a policy error in 2022 by tightening monetary policy more quickly? If in fact the Fed has the transitory characterization of inflation wrong and we see self-perpetuating upward pressure on consumer prices throughout the course of the next two or three quarters, then the Fed would arguably be a bit behind the curve. The flip side is, if in fact the FOMCs assumptions regarding the nature of inflation pan out and we see a steady drift back to pre-pandemic style inflationary pressures, then if the Fed chooses to accelerate tapering and/or bring forward a rate hike, then the risk quickly becomes that the Fed is effectively putting the brakes on the real economy too quickly.
Demand-driven Inflation?
A question would be that given we’re seeing what is ostensibly a tight labor market and upward pressure on wages, doesn’t that risk the self-perpetuating nature of inflation driven by higher wages, more capacity to consume and higher propensity to consume that would trigger a runaway acceleration in consumer prices? Unlike the supply-driven inflation, the demand side inflation that higher interest rates would be very effective at combating. And what we heard from Powell is, that’s not at all what the Fed is thinking. At this point, the low participation rate, distorting the traditional Phillips curve narrative, and this latest increase in wages is a function of temporary or transitory distortions on the supply side of the labor market.
As what we see in today’s job report, the participation rate remains unchanged at 61.6%. And this is, again, what Powell focused on in his press conference, that the reluctance of workers to reenter the labor force has been much more pronounced than what the Fed was anticipating. At 61.6%, the current participation rate is hardly in a zone that would be encouraging for the FOMC.
Beyond that, there’s some nuance within the unchanged labor market participation rate that’s worth highlighting. Specifically, we did see a decrease in labor market participation for the 55 and older cohort, and a slight increase for the balance of the labor force. So, this is very consistent with the idea that expiring extended unemployment benefits have prompted some workers to reenter the market, while elevated asset prices have brought forward the retirement plans of many in the labor force. All of this does risk a sustainably higher trend in wages. However, when we look at the year-over-year pace of average hourly earnings at 4.9% versus what we have seen in terms of headline CPI gains, what it suggests is that wages are still struggling to keep up with prices. So, on real terms, consumption might continue to face headwinds into the end of the year. This is particularly troubling not only to retailers, but also to the overall pace of the recovery.
All About Macros 