Is the Fed about to pivot on rates?
Ahead of Wednesday’s Fed meeting, many are asking when interest rates will peak and if there’s a risk of over-tightening. We assess what might come next from a central bank that must balance a potential pivot with a strong signal to companies that it’s determined to beat inflation.
For central banks, increasing interest rates from the low levels set in the pandemic has not been difficult when faced with a rebounding economy and high inflation. The difficult part is knowing when to stop. Monetary policy works with “long and variable lags”, making it hard to judge when interest rates have reached the level needed to bring inflation down. An interest increase today can take up to two years to have its full effect on the economy.
Such lags can cause central banks to over-do it. It is not unknown for policymakers to inadvertently follow a “grand old Duke of York” strategy, of marching rates up to the top of the hill to tame inflation only to have to march them back down again as the economy crashes into recession.
Of the major central banks, the US Federal Reserve (Fed) is clearly approaching the point where the question of how high rates need to be is on the agenda. Market rumours suggest that the Fed’s rate setting committee will debate whether to slow the pace of tightening after hiking by an expected 75 basis points on 2 November.
Should the Fed follow with another 75 bps rise at its December meeting, US rates at 4.75% will be approaching levels last seen in 2006, when rates eventually peaked at 5.25% later that year, before falling sharply in 2007 as the financial crisis hit the world economy. Should the Fed instead slow the pace of tightening, many would see this as a pivot in policy and an important signal to markets.
In Europe, the debate on the terminal – or peak - rate has yet to heat up as the European Central Bank (ECB) and Bank of England are at an earlier stage of their tightening cycles. Nonetheless, with inflation in both regions running above 10%, the pace of tightening is increasing with the ECB making a second consecutive 75 bps move this month and the Bank of England expected to follow suit when it meets later this week.
To focus on the US, recent figures indicate the economy picked up in the third quarter with GDP rising 2.6% (quarterly annualised) after a decline of 0.6% in the second quarter. However, the bounce in GDP was largely driven by a pick-up in net export trade as bottle-necks eased while underlying domestic demand remained sluggish.
The easing in supply chains is welcome and has also been reflected in softer goods prices; however, business surveys such as the ISM suggest that this will be a one-off as inventory levels are now in line with consumer demand. Meanwhile, the housing market, which has borne the brunt of the tightening in monetary policy, continues to slow sharply (see charts here).
The slowdown signalled by these indicators looks set to persist. Longer leading indicators such as the Conference Board index have also turned negative and are signalling a recession, as the chart below shows. This index picks up recent financial market volatility in some of its components and more generally we would highlight how market conditions have tightened through weaker equity and bond markets and a stronger US dollar.
Such moves are helping to quell inflationary pressure, particularly through higher long-term interest rates, which have pushed mortgage rates above 6% and made financing more expensive for companies who have slowed issuance. Meanwhile, the stronger dollar is weighing on import prices, directly helping to contain inflation.
Two signals that a peak in rates is in sight
To be confident that the Fed is closing in on a peak in rates and a potential pivot though we need to see two further conditions fall into place. The first would be evidence that inflation is falling, and the second that the labour market is weakening.
Headline CPI inflation appears to have peaked at 9.1% year-on-year in June and was running at 8.2% in September. The turn has been largely driven by an easing in commodity price inflation, with gasoline prices falling back below $4 / gallon. However, the decline has been less than would have been expected given the move in broad commodity prices (see chart below) as core inflation (CPI ex.food and energy) has picked up from 5.9% to 6.6%. Inflation is now broad-based, having spilled over into the wider basket of items, particularly services, as the chart below shows.
Going forward, we expect inflation to moderate as weaker demand restricts the ability of firms to pass on cost increases. Slower global growth should also weigh on commodity prices. Meanwhile, one of the major drivers of higher core inflation, the cost of shelter, should moderate as the housing market turns down. This is one of the stickier items in the CPI as rents change infrequently; however, it is expected to moderate in 2023 and help bring core inflation down to just under 4% by year end. The S&P CoreLogic Case-Shiller house price index fell 1.1% in August, the biggest decline since 2011 and there are signs rental demand is falling following a rapid rebound after the pandemic.
Labour market is key
Key to a sustained fall in core inflation is a weakening of the labour market, which so far has remained resilient in the face of this year’s slowdown in growth. The unemployment rate fell to 3.5% in September (well below estimates of equilibrium at 4.5%), payrolls continue to grow and although job openings have fallen slightly there are still nearly two vacancies for every unemployed person. The labour market remains tight.
One factor which has exacerbated the problem has been the fall back in the participation rate as workers have decided not to return to the labour market after the pandemic. Retirement and long term illness have played a role here and the participation rate remains 1.1% below pre-Covid levels, which is equivalent to 1.8 million workers. Higher participation would help ease supply shortages, but in the meantime wages are rising and adding to cost pressures.
For this to change we need to see a pivot in the behaviour of firms. In many ways corporate behaviour has been puzzling this year as the consequence of slower growth and rising employment has been the weakest productivity growth on record (see chart).
Normally this would be expected to trigger a response and the latest corporate earnings season has seen reports of weaker demand and less pricing power, particularly in tech, which did so well during the pandemic. However, so far there is little sign of a broad and significant workforce restructuring. Hire rates are slowing, but remain positive, people say they have little trouble finding work and lay-offs remain low by the standards of the past 20 years.
In our view firms have only been able to tolerate weak productivity and the subsequent surge in unit wage costs through being able to pass them on in higher prices. Otherwise margins would have been crushed as labour costs surged. Instead firms have been beneficiaries of high inflation. As a result, whilst household cash flows are under pressure, the corporate sector is yet to see the sort of squeeze which would trigger a retrenchment.
We see this through the flow of funds accounts which shows the corporate sector still running a financial surplus where internal cash flow exceeds investment. In previous cycles a deterioration in this balance and dip into deficit has been a reliable indicator of recession (see chart 7). This is the point at which companies begin to have funding problems as they have to tap into external sources to maintain current expenditure. Very often this results in a retrenchment as lenders and other capital providers seek reassurance that the business is viable.
To tie this together - what do we know? Demand is weakening and a number of indicators are signalling recession. Meanwhile, the labour market remains tight with low unemployment and more vacancies than unemployed. Productivity is terrible and unit wage costs are surging. However, companies do not look set to embark on a major retrenchment.
It would seem that unless growth is much better than recorded, firms have been able to pass higher costs on to their customers through higher prices which, of course, has sustained high inflation. This has helped corporate cash flows remain buoyant and positive after investment, so they are not under external pressure to retrench. A conclusion reinforced by the third quarter earnings season so far: some downgrades, but no great calamities.
How will this change?
We do not expect this situation to be sustained – if companies keep passing on costs then inflation will remain high and the Fed will have failed. Instead, it seems more likely that monetary policy will continue to bear down on demand to bring it into line with supply. Markets are helping (strong dollar, higher bond yields, weaker equities and credit) and quantitative tightening is playing a part as the Fed shrinks its balance sheet. Nonetheless, we are not at the point where the corporate sector is about to pivot. And that restricts the Fed’s room for manoeuvre.
There is still a chance of a Fed pivot at its meeting on 2 November, with the central bank signalling an easing in the pace of future tightening. It will be aware of the lags from policy to the economy of the risks of over tightening and having to follow a “Grand old Duke of York” strategy. However, it will also have to balance this with a strong signal to the corporate sector that it is determined to beat inflation and that the current situation cannot continue,even if that means a recession.
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