For months, as the Federal Reserve steadily ratcheted up its war against inflation, Fed Chief Jerome Powell insisted that policymakers had everything under control. He stressed that no recession for the U.S. economy was in sight.
The Fed’s confidence was underscored by its picture-perfect economic outlook in mid-March. The central bank saw the jobless rate stabilizing at a half-century-low 3.5% while the inflation rate gradually descended to 2%.
Yet, suddenly, Powell no longer sounds so reassuring. “There could be some pain involved in restoring price stability,” he said last week at The Wall Street Journal’s Future of Everything conference. He added that the unemployment rate may “move up a few ticks.”
Powell’s new message weaves in hopeful talk about plausible “pathways” to a “softish” economic landing. So it may be possible to miss the big picture: He’s about as close as it gets to a Fed chair whispering “fire” in a crowded theater.
So what’s going on? The Federal Reserve is already tightening policy with both fists. It’s hiking its benchmark interest rate in half-point increments and about to reverse pandemic asset purchases by $95 billion per month. Mortgage rates have spiked from below 3% to above 5%. Yet Powell is signaling that all of that may not be enough.
The longer the economy runs and the lower unemployment gets, the higher the Fed will likely have to hike rates to unwind economic excess and tame inflation. And the worse the ultimate recession will likely be.
“The Fed could be faced with a Hobson’s choice: Push the economy into a mild recession” to tame inflation, “or wait and possibly cause a more significant recession,” Ryan Sweet, economic research director at Moody’s Analytics, wrote in a May 12 note.
So, with little margin for error, Powell is drawing a line in the sand to keep the jobless rate from falling further and ultimately to push it higher. And that line in the sand may apply to the stock market as well. After decades of riding to Wall Street’s rescue, a sustained rally might be the last thing policymakers want right now.
Fed Chief Powell’s Bully Pulpit
Former Fed Chief Ben Bernanke observed this week that “monetary policy is 98% talk and 2% action.”
Powell may be using his bully pulpit to try and convince businesses that pain is coming and that they should act accordingly. The megabanks that the Federal Reserve regulates have gotten the message and are beginning to preach the same downbeat tone. CEOs from the likes of Goldman Sachs and Wells Fargo are suddenly warning that recession may be in the cards.
There’s “no question” the economy is headed for a downturn, Wells Fargo CEO Charlie Scharf said at the same WSJ conference at which Powell spoke last week.
The Fed’s message also appears aimed at Wall Street. The S&P 500 retrenchment briefly crossed the 20% bear-market threshold last week, as Powell seemed to shut the window on a fledgling rally.
Fed officials “might be secretly cheering” the stock market sell-off, “hoping these flames will do just enough demand-side economic damage to solve their supply-side inflation woes,” Jefferies chief market strategist David Zervos wrote.
Despite some “volatile days,” Powell told the WSJ conference that financial markets are “getting through this pretty well.”
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Last year’s economic boom, fueled by vaccines and stimulus, has clearly downshifted. That’s been most evident as the tech sector pulls in its horns. Amazon.com (AMZN), after roughly doubling employment over the past two years to 1.6 million, is “no longer chasing physical or staffing capacity,” the company said on April 28 as it predicted that sales growth would slow to a crawl in the current quarter.
The weakness extends well beyond online sales. Amazon rivals Walmart (WMT) and Target (TGT) set off a retail stock bloodbath last week as they both reported weak earnings and guidance. Yet a closer look at what happened offers a more mixed picture.
The big retailers’ struggles didn’t stem from a shortfall of demand, but from higher labor and logistics costs and “having stocked up on the wrong inventory,” wrote Jefferies Chief Financial Economist Aneta Markowska.
After staffing up in January amid omicron-related absences, Walmart saw almost all absent workers return in February, faster than expected. “Weeks of overstaffing” was resolved “primarily through attrition,” CEO Doug McMillon said on the May 17 earnings call.
Both Walmart and Target said they were stuck with excess inventory because buying patterns changed more than expected. Target noted a downshift in spending on TVs and furniture, while other categories like fashion and luggage showed strength.
A surge in gas prices that gained steam after Russia’s invasion of Ukraine also forced consumers to alter their spending.
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That’s had some consumers with stressed budgets shifting to less-expensive private-label grocery items, Walmart said. Yet despite those pockets of weakness, both major retailers said their customers aren’t pulling back.
“We just continue to see a resilient consumer,” Target CEO Brian Cornell told analysts. “Our traffic numbers are up to start the second quarter.”
Walmart’s McMillon said, “We expect the solid top-line performance to continue, and we’re taking up sales guidance for the year.”
Even as Americans spend more on travel and entertainment, April’s retail sales report backed up Walmart and Target’s perception of consumer strength. Sales rose 0.9% after March’s upwardly revised 1.4% gain.
Despite higher gas prices and lower 401(k) values, the combination of strong wage growth, elevated savings and ample borrowing capacity are likely “to sustain above-trend consumption growth this year, even in the face of high inflation,” Markowska wrote.
She figures that American households have lost $8.5-trillion in financial wealth this year, partly offset by a $3-trillion rise in real estate values. The net $5.5-trillion decline, though large, amounts to just 4% of total wealth, which has been in “a position of extreme strength.”
With strong household balance sheets supporting consumption, “maybe the Fed has to be even more aggressive” to tame inflation, Minneapolis Fed President Neel Kashkari, among the more dovish central bankers, said last week.
“We are doing everything we can to achieve a soft landing, but I’ll be honest with you: I don’t know the odds of us pulling that off,” Kashkari said.
Consumer spending is likely “to remain healthy until the labor market begins to crack” once interest rates get high enough, Markowska says. So far, despite layoffs among tech startups and mortgage companies, she’s seeing “no evidence that hiring conditions are deteriorating.”
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Job Market Too Tight
The Federal Reserve has managed soft landings in a few rate-hike cycles since World War II. However, Fed chief Powell admits that today’s economy looks nothing like those that averted recession.
“We’re in a world of firsts,” Fed chief Powell said last week. He reeled off a list that included a once-in-a-century pandemic, lockdowns in China, and a war in Europe between two major commodity producers.
The resulting supply constraints, combined with a surge in spending, set off the biggest inflation outbreak in four decades.
But the key difference now for Fed policymaking is labor market tightness.
“I’m not aware of a time when we’ve had two job openings for every unemployed person,” Powell said.
The latest Labor Department data shows 11.5 million job openings vs. 5.9 million unemployed.
Powell spelled out the potential path to a soft landing in his May 4 news conference: “By moderating demand, we could see vacancies come down,” creating a better balance between labor supply and demand.
That would help “get wages down and then get inflation down without having to slow the economy and have a recession.”
If more sidelined workers rejoin the labor force, that could help restore balance. That’s the hope. But the Fed’s focus is cooling demand.
Federal Reserve’s Blunt Tool-Kit
To some extent, Powell’s hope for a pullback in job recruitment is coming to pass, especially in the tech sector. Meta Platforms (FB), Twitter (TWTR), Snap (SNAP), Nvidia (NVDA), Salesforce (CRM) and Uber (UBER) have recently instituted hiring slowdowns or freezes. Netflix (NFLX) is cutting jobs.
Bank of America economist Stephen Juneau cited Revelio data showing that new job postings — a subset of total postings reflected in Labor Department data — tumbled by 2 million to a still-high 6.6 million in April.
Yet some see Powell’s plausible path to a soft landing as unlikely. Monetary policy is “a blunt instrument,” Peter Hooper, global head of economic research at Deutsche Bank, told IBD.
“They don’t have the ability to eliminate job openings” without hitting demand in a way that’s likely to spur layoffs, particularly in interest-sensitive parts of the economy, Hooper said.
To quell inflation, Hooper expects the Fed will have to tighten enough to push the unemployment rate “toward 5%.”
Fewer job listings won’t be enough to avert continued tightening at a brisk pace. Powell laid out a pretty clear test for a shift in policy. “What we need to see is clear and convincing evidence that inflation pressures are abating and inflation is coming down.” Inflation pressures include the low unemployment rate and its impact on too-high wages.
“If we don’t see that then we’ll have to consider moving more aggressively.”
Services Inflation Still Rising
Goods inflation may already be past the peak. The April consumer price index showed core goods prices, excluding food and energy, rose 9.7% from a year ago. That’s down for a second month from February’s 12.3% surge. However, nonenergy services inflation accelerated to 4.9% in April, the highest level since 1991.
That’s a big deal because such services including housing, medical care, transit and education account for 57% of consumer budgets.
Likewise, the Fed’s preferred inflation gauge, the personal consumption expenditures price index, on Friday showed the overall inflation rate easing to 6.3% from 6.6%. But services inflation picked up to 4.6% from 4.5%. The report also showed stronger-than-expected consumption, with spending up 0.9% on the month and March’s figure revised up to 1.4%.
So far, despite such hits to household budgets, consumers have kept spending, helped by the biggest wage gains in decades. With an “unhealthy level” of labor market tightness, according to Powell, workers have been in a position to demand wages that largely offset cost-of-living increases. For their part, employers are doing what they can to pass those costs on to customers.
For example, HCA Healthcare (HCA), which says it’s facing up to $500 million in extra labor costs this year, is among a number of hospital operators seeking outsize rate increases from health insurers to offset wage hikes. Hospitals are seeking price hikes of 7.5%-15%, far above their usual ask of 4%-6%, the Wall Street Journal reported recently.
“The longer high inflation lasts, the more likely it’s going to be embedded in expectations” — including worker expectations for wage increases, Hooper said.
That’s why further unemployment declines would make the Fed’s job even harder, and likely require additional rate hikes to stem.
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To a large extent, the descent to the edge of a bear market has surprised Wall Street.
Investment strategists mirrored Powell’s earlier emphasis that strong household balance sheets should help the economy withstand monetary tightening. Plus, the first Fed rate hike only came in March. For now, the central bank is merely pulling back on easy-money policy, not hiking rates to restrictive levels.
Even those bearish on the economy have made a similar case. Deutsche Bank economists, among the first to make a recession call, see late 2023 as the likely date. They think it will take a while for the economy’s strengths to give way.
Stocks soared on May 4 as the Fed instituted its first half-point rate hike since 2000 and approved unloading some of the $4.5 trillion in bonds that it bought during the pandemic. The feeling seemed to be that the Fed’s hawkish surprises were past.
Yet the real shock is that the Fed is telegraphing “pain” and determined to keep tightening into a slowdown.
“It’s unusual to have this much advanced warning that the Fed is going to have to step on the brakes,” Hooper said.
Ed Yardeni, chief investment strategist at Yardeni Research, this week upped his recession odds to 40%. “If a recession is about to happen, it will be the most widely anticipated downturn in history,” he wrote.
Recessions usually happen when the Fed tightens too much in periods of speculative excess or overindebtedness, accidentally triggering a credit crunch. This time, if there’s a recession, it won’t be an accident.
With services inflation still rising, the Fed can’t risk that inflation will become further entrenched. Policymakers appear to be drawing a line in the sand around the current 3.6% jobless rate. Officials also may be drawing a line in the sand — or near-term ceiling — for the stock market near current levels.
Fed Policy Working Fast
Fed policy works on the economy indirectly, by influencing financial conditions — a combination of market interest rates, stock valuations, credit spreads and the ability of companies to raise capital. If the Fed needs to cool demand, policymakers won’t want household wealth to recoup much of this year’s moderate losses.
The other thing notable about current Fed policy is the speed at which financial conditions are tightening. The 30-year mortgage rate has surged 2.25 percentage points over the past year. That’s the fastest jump since the 1982 recession. With a sharp slowdown in sales, the supply of new homes for sale just jumped to 9 months, the most since the post-housing crash in 2010.
Meanwhile, Yardeni noted that the S&P 500’s intraday fall into bear-market territory came 136 days after the Jan. 3 peak. That’s awfully fast, relative to history. The S&P 500 took 274 days to fall by 20% from its October 2007 high and 353 days to reach bear territory after peaking in March 2000
Bottom line: The speed at which the economy loses steam may also catch people off-guard.
Be sure to read IBD’s The Big Picture column after each trading day to get the latest on the prevailing stock market trends and what they mean for your trading decisions.
Please follow Jed Graham on Twitter @IBD_JGraham for coverage of economic policy and financial markets.
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