If there’s one takeaway from another entrenched jobs report, it’s this: The Federal Reserve is behind the curve and falling rapidly. Investors should be prepared for — and even welcome — more aggressive tightening.
As in the previous month, the headline non-farm payrolls figure for December belies a report that shows a stubborn, ongoing labor shortage fueled by inflation. Millions of workers continue to defy expectations of a massive return to work, with labor-force participation well below pre-pandemic levels. And the 0.6% increase in hourly wages since November reflects how quickly employers are paying to attract help.
Ed Yardney, president of Yardney Research, says his earned income for salaries and wages in the private sector has grown by 0.8% from a month ago and 9.9% from a year ago. Wages that surpass inflation sound good for purchasing power, but the dynamic is also a red flag for the dire wage-price spiral that characterized the 1970s.
What’s more, the unemployment rate of 3.9% is now below what the Fed has called the natural rate of unemployment, or the lowest rate of unemployment where inflation is stable. When the unemployment rate fell below 4% during the last expansion, the Fed was already more than two years into the rate hike cycle and almost a year into its liquidity evacuation program, says Michael Darda, chief economist and market strategist at MKM Partners. Was more.
“The Fed is behind the curve relative to the previous cycle based on almost all relevant employment metrics,” Darda says. His model for a neutral interest rate, which represents an equitable economy, continues to move higher. If the policy rate is stable near zero, while the neutral rate rises, the Fed becomes more lenient against default, he says.
It gets worse. Darda says that a rising neutral rate means that the so-called velocity of money is likely to increase, with the faster rate of money trading leading to an increase in demand that the economy cannot handle and thus exacerbating already hot inflation. Is.
So where do we go from here? The growing consensus for March’s interest-rate liftoff, with two rate hikes later this year, is the easy part. It’s also somewhat meaningless unless the Fed does the arduous task of shrinking its $9 trillion balance sheet.
The shrinking balance sheet is enough to put many investors to sleep. When the Fed began balance-sheet normalization in 2017, Fed Chair Janet Yellen suggested it would “run quietly in the background” and be as exciting as “watching the paint dry.” But this time it seems appropriate to do so thoughtfully. At the time, the balance sheet was half the size it is today and, as Citi economist Veronica Clark says, there is a growing sense that Fed officials think the asset purchase program in response to the pandemic is too big and has gone on too long.
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In recently released minutes from their December meeting, central bankers indicated they may begin closing balance sheets sooner and more aggressively than the market expected. Clark forwards his expectation of normalization to begin in July, meaning the Fed will begin with a monthly decline of $25 billion in reinvestment as securities mature and ramp up to a monthly decline of $75 billion in reinvestment. come.
Barry Knapp, director of research at Ironsides Macroeconomics, says the December jobs data reinforces the argument for earlier and sharper balance-sheet contraction. Fed officials waiting for full employment have missed the boat, they say, calling current monetary policy “reckless” and asserting that the Fed will not actually tighten policy unless its own holdings decline. Don’t be
The idea: The Fed owns about a third of the Treasury and mortgage markets and long-term rates won’t really go up until the Fed’s footprint is reduced. If the bond markets are not speaking for themselves and adjusting accordingly, the rate hike will in itself be ineffective.
“They’re clearly starting to tighten up and things are really loosening up,” Knapp says, referring to the still negative inflation-adjusted real interest rates despite the Fed’s hawkish pivot. “They start the taper process and the market laughs at them,” or it seems because the bond market is so distorted by the effects of Fed asset purchases.
In a traditional way, it all sounds like a recipe for ditching stock. But Knapp says the opposite is true, at least for those with little patience and keen on the idea that monetary policy that is too favorable hinders growth. Consider the housing market, flooded by a push aside by investors who will be first-time buyers, which Knapp says have a much greater multiplier effect on the economy than renters, and consider the additional deposits that banks make. Will lend at higher rates.
Knapp says that for this specific period – roughly the first half of this year – the removal of liberal monetary policy will be difficult for markets, but will be a net positive for the economy. He sees a 10% to 12% drop on tap for major indices due to the tightening, and suggests investors see this simply as a great buying opportunity.
For the time being, there’s going to be talk about tightening the Fed into a slowing economy — especially as Omicron begins to sway the always-on economic data. But the forest is worth seeing for the trees. The tightening — in this case, the real kind, which includes balance sheet reductions — could help offset counterproductive forces and prevent the Fed from falling even further behind the curve on inflation that could in the coming months. It’s going to get worse.
Write Lisa Beilfuss [email protected] Feather