Ajay Rajadhyaksha is global chair of research at Barclays.
The last Federal Reserve meeting of the year is looming, and all the talk is about a so-called ‘pivot’. Yesterday’s softer inflation data has only fuelled the chatter.
For sure, the Fed will almost certainly trim the sizes of its rate increases when its decision is announced later today. From there, it should be a hop, skip and jump to rate cuts. At least, that is what the bond market believes — fed funds futures are now pricing in three quarter-point cuts next year.
Not so fast.
The Fed has moved exceptionally fast this year. But it could hardly fail to, given the economic backdrop. It is not hard to tighten monetary policy aggressively when headline inflation is near 8 per cent, when wage growth is twice as hot as it was with the same pre-Covid jobless rate, and when even the White House is supportive of tighter policy.
Next year will be a whole different ballgame, with much trickier decisions to make.
For one thing, US inflation has peaked and will continue to fall next year; yesterday’s CPI print was one more brick in that wall. Higher rates hit activity through long and variable lags. Because the hikes has been so quick, they just haven’t had time to affect large parts of the US. That will change in 2023.
For example, 2022 has seen a very tight US labour markets. But lay-offs will start as the economy slows down. Economists on average expect the jobless rate to rise to 4.8 per cent by the first quarter of 2024, from today’s 3.7 per cent. That’s a million and half fewer jobs created, and several months of negative payroll prints.
Yet the Fed’s median ‘dot’ for end-2023 is at 4.6 per cent and will probably go up this week. The Fed believes that the ‘neutral’ fed funds rate is 2.5 per cent, and yet it plans to keep rates more than 2 per cent above this steady-state, amid a recession and millions of job losses.
There’s a reason for this, of course. The Fed is worried that the labour market is still too hot and wages too steamy to get back to ca 2 per cent inflation. For example, the Employment Cost Index (one of its preferred wage gauges) is now at 5 per cent annualised; it was 2.7 per cent in Dec 2019 and never rose above 3 per cent in the decade before Covid.
Other measures, such as the Atlanta Fed’s wage tracker and average hourly earnings, are all running at 6-6.5 per cent. And since wages feed into services prices — which is 70 per cent of the US inflation basket — the Fed feels that the path to 2 per cent inflation is through a sharp slowdown in wage growth.
That likely requires job losses, and lots of them.
The central bank can hardly say this publicly, but a rise in the unemployment rate and, thus, a slowdown in incomes is now a policy goal. Which is why, when said job losses start, the Fed can hardly rush to the rescue by cutting rates quickly.
Holding firm will not be an easy thing to pull off. Already, senators such as Elizabeth Warren, Sherrod Brown, and John Hickenlooper have urged the Fed to calm down. Next year, if job losses start and then intensify, there will be an ever-rising drumbeat about the Fed’s “war on workers” and immense pressure on the central bank to cut rates.
The problem is that this could mean that wages and core inflation never slow down enough, setting the stage for a lasting loss of inflation credibility for the Fed.
And then there is one final scenario to consider. Even if the US unemployment rate rises by 1 per cent next year, it will still be 4.7 per cent. From a historical standpoint, that is low. In fact, it wasn’t so long ago that the Fed believed “full employment” required a 5 per cent or higher jobless rate.
In other words, there is some chance that the jobless rate rises sharply next year, but still not to levels that slow wage growth materially. That would be the worst of all situations.
The Fed might then be faced with the ghastly task of hiking further — say, in a year from now — even as workers are being laid off and politicians are crying themselves hoarse asking for cuts. This is not the Fed’s baseline forecast, and neither is it mine. But it’s not a completely implausible scenario and would put the central bank in a very difficult situation.
After a frenetic rate hiking cycle officials in the Eccles building will no doubt hope that the heavy lifting is over and that they can look forward to a well-deserved holiday break. They should enjoy themselves. Because next year might be much trickier year.
December 14, 2022 at 12:30PM
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Now comes the hard part - Financial Times
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