The biggest reason for optimism that a Federal Reserve-induced recession can be avoided next year has just been reviewed. Upward revisions to hourly wages in September and October and an even bigger jump in November pushed wage growth well above the range consistent with the Fed’s 2 percent inflation target.
A near-consensus is emerging that the only hope for the U.S. economy to avoid a hard landing and a bigger drop in the S&P 500 is for the Fed to raise its inflation target — at least in practice. The Fed may be willing to do so, but it would still need some additional cooling before ending rate hikes.
The 2 percent inflation target is “much more elastic than the Fed can afford because I don’t think there’s an electorate that needs bloodshed,” RSM chief economist Joe Brusuelas told IBD.
Brusuelas estimates that the Fed would need to raise unemployment to 6.7% to restore 2% inflation. But most of the way – to a 3% inflation rate – could be achieved by a much smaller rise in unemployment to 4.6%, while still sacrificing 1.7 million jobs.
“If the Fed pushes hard for 2 percent inflation, that may require more rate hikes and a higher final rate than is already baked into the pie,” said Joe Quinlan, head of market strategy at Merrill & Bank of America Private. Bank. “This could be an overdose of monetary tightening,” triggering a sharp recession in the U.S. economy and profits.
But Quinlan also sees the potential for a more optimistic outcome. If inflation continues to fall toward 3% and Fed policymakers “take their time” instead of forcing a release, he expects markets to rally.
“I wouldn’t be surprised if the Fed’s new inflation target was maybe around 3% to 3.5% two years from now. That’s certainly within the realm of possibility and certainly acceptable to all parties.”
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Two percent inflation target exceeded?
The Fed’s 2% inflation target, unofficially adopted in 1996 and official since 2012, is increasingly seen as an anachronism. Inflation has been below the target for most of the last decade. But the 2% target now seems incompatible with a world where disinflationary trends have reversed.
“The 2% target was eclipsed in the golden age of globalization; strained but efficient supply chains; labor abundance from emerging markets including China; productivity increases due to technology,” Quinlan said. “That can be mostly behind us”.
Goldman Sachs Asset Management strategists James Ashley and Simona Gambarini wrote last month that current high inflation may not only be cyclical — a product of strong demand and pandemic-related supply constraints — but also structural, “driven by forces such as aging demographics, deglobalization and decarbonization.”
“As a result, policymakers may need to re-examine the appropriateness of 2 percent inflation targets,” they wrote.
Federal Reserve Chairman Jerome Powell said in a speech on November 30 that the US labor force is 3.5 million workers smaller than forecast before the pandemic. This reflects less immigration and more than 2 million early retirements due to Covid.
Still, the S&P 500 rallied as Powell talked about easing price pressures. Commodity inflation has moderated and housing inflation will follow in 2023, with rental prices for new homes already falling sharply, he said. Coupled with the continued decline in oil prices, the inflation rate looks set to continue falling in the coming months.
But Powell played down that progress and tried to focus attention on areas where inflation is not easing: services other than energy and housing.
“This is perhaps the most important category for understanding the future development of core inflation,” Powell said. “The labor market holds the key” because wages represent the biggest cost in providing these services, such as health, education, catering and hair cutting.
Powell explained that 3.5 percent wage growth is consistent with the Fed’s 2 percent inflation target, assuming productivity growth of about 1.5 percent.
Wage growth is too hot
Current measures of wage growth, including the hiring cost index and average hourly earnings data in the monthly jobs report, are about 1.5 to 2 percentage points above where they should be, he said.
Initially, Powell’s speech calmed fears that the Fed would tighten too much. That’s because the previous few jobs reports suggested slowing wage growth. In fact, preliminary data showed that annual growth in average hourly wages fell to 3.9% from August to October. That was not far above Powell’s 3.5% wage target to return inflation to 2%.
But the November jobs report, released two days after Powell’s speech, blew up that promising scenario. Annual growth in hourly wages increased to 5.1%, while the most recent three-month trend showed annual wage growth of 5.8%.
The jobs report showed that “the Fed’s hike cycle is likely to last longer than markets expected,” Nomura senior economist Rob Dent told IBD.
A hard landing scenario for the US economy
Nomura has been in the hard landing camp for some time now. Dent argued that Wall Street underestimated how entrenched inflation had become and “the Fed’s determination to cut it, even at the expense of a recession.”
Dent and his colleagues think a path back to 2% inflation is feasible, but the Fed will raise its key interest rate to 5.5%-5.75% – at least half a point higher than markets expect – with the latest hike in a quarter points of May. This would push unemployment well above 6% in 2024, despite a likely rate cut by September 2023.
Would the Powell Federal Reserve really jump that far and risk that much economic fallout? As Nomura economists point out, the Fed’s latest projections show solid, if modest, GDP growth through 2023 and 2024.
Policymakers may be overly optimistic about the underlying economic strength of the United States. However, Powell’s recent comments confirming that policymakers will “slow down” to avoid an overshoot were somewhat reassuring. “If we were to collapse the economy” by continuing to rapidly raise Fed interest rates, Powell said on Nov. 30, “we might get rid of inflation. But at a very high human cost.”
Still, as long as employment is rising and wage growth remains close to 5%, it’s hard to expect the Fed to stop raising interest rates entirely.
Another half-point hike to a range of 4.25%-4.5% is a sure thing for the Fed meeting on December 14th. So the key question is whether the data can change quickly enough to avoid further increases in February, March and May. Otherwise, a hard landing would be more likely.
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Railroad wage increases herald broad-based wage increases
The latest signs of wage growth from an inflationary perspective are not encouraging. “After a year of significant cost-of-living increases, workers will look to make major business adjustments” for 2023, Jefferies chief financial economist Aneta Markowska wrote in a Dec. 2 note. Given the tightening conditions on the labor market, employers will be “forced to make concessions on wages”.
November’s surprising 0.6% monthly jump in average hourly wages was driven by a huge 2.5% rise in wages for transport workers. This probably stemmed from recent national rail labor negotiations, Markowska writes. Six of the 12 unions approved the deal in September or October, so the immediate 14 percent wage increase was likely to be reflected in the November jobs report. He expects traffic pay to increase in December as the wages of the other six unions jump.
Meanwhile, U.S. corporations are projecting a 4.3 percent wage increase in 2023, the most since 2001, according to a Conference Board survey. The latest survey by the National Federation of Independent Business found that 32% of companies are expected to raise wages in the next three months. This is the most since December 2021.
Faster wage inflation will “diminish hopes for an earlier Fed pause,” Markowska wrote. It could also create a tipping point for unusually high profit margins. He expects pricing power to fade in the first quarter as wage and interest costs rise, particularly for small businesses. This will set the stage for cost cutting, layoffs and possibly a hard landing.
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Fed chief Powell says there is no “premature” easing
Markowska believes that the recession could last for five quarters. After its aggressive tightening to temper the financial strength of households and businesses, the Fed is likely to be slow to respond to U.S. economic weakness, he says.
“History provides a strong warning against premature easing of policy,” Powell reiterated on November 30.
Since his speech in Jackson Hole in late August, Powell has made it clear that the Federal Reserve wants not only to quell the biggest burst of inflation in 40 years, but to avoid the policy mistakes of the 1970s.
Faced with rising unemployment in 1970 and again in the middle of the decade, the Fed reversed rate hikes before wage pressures subsided. This fueled chronic inflation that would require double-digit interest rates and unemployment to resolve under Fed Chairman Paul Volcker in the early 1980s.
Dean Baker of the liberal Center for Economic and Policy Research is among those who think Powell’s focus on the 1970s is misplaced.
“If you were looking at a spiral between wages and prices, you’d like to do something. You don’t want inflation to just go higher and higher. But obviously we’re not in that story,” Baker said. “Back then, we had much stronger unions. We had a much less dynamic economy.”
Baker believes Powell has “a lot more room” than Volcker to take a wait-and-see approach and stop raising interest rates soon to ensure unemployment doesn’t rise more than necessary.
Stronger arguments for a higher inflation target
Olivier Blanchard, former chief economist at the International Monetary Fund, says the reasons for the Fed’s higher inflation target, first set in 2010, are only getting stronger.
When inflation and interest rates are around 2% or less, the Fed has little room to cut rates to support the faltering U.S. economy, Blanchard wrote in a recent column for the Financial Times. And while the Fed can resort to asset purchases, it has limited impact and “harmful side effects.”
Blanchard argues that the U.S. should let inflation rise, but not so high that households and businesses really notice and change their behavior. For the US, he says the right target is probably 3%. He cites a new paper, Inflation and Attention Thresholds, which finds that the frequency of Google searches for inflation starts to rise noticeably when inflation exceeds 3.55%.
A higher inflation rate is not a free lunch
While there are technocratic reasons for raising the Fed’s inflation target, Brusuelas sees it as bowing to reality. He says inflation has been reset higher due to the labor force hit by Covid and the US bringing home production of strategic goods to reduce reliance on China.
“We’re choosing to pay higher commodity costs and higher labor costs,” he said, “and that’s going to cause slower growth.”
Follow Jed Graham on Twitter @IBD_JGraham to cover economic policy and financial markets.
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