By Co-Founder & CIO, Dr. Charles Lieberman
The Fed would like to leave policy unchanged until it becomes clear whether it has succeeded in slowing down growth sufficiently to bring inflation back towards 2%. Turmoil in the banking system brings them closer to that objective, although in an undesirable way. Growth is slowing and may moderate further. Even so, a recession is far from assured, as yet. And inflation may not recede to target. So, the Fed must now give it some time to see what’s been accomplished.
Growth has moderated. A good-sized decline in job openings in March was followed by a solid job increase of 253,000 in April that is more moderate than the six-month average of 290,000, but hardly enough of a slowdown to assure the Fed that a trajectory towards 2% inflation is assured. A 0.5% rise in average hourly wage rates and a decline to a 3.4% unemployment rate implies that there is plenty of wood left to chop. The bond market is still priced for multiple policy rate decreases starting this summer, Fed warnings that this is unlikely to happen notwithstanding.
The implosion of regional bank stocks adds to the tumult. It doesn’t appear that careful analysis is useful. First quarter earnings reports show that banks have plenty of capital, including those that got hammered this week. One survey reported that a majority of depositors are nervous about their bank, which implies they have been watching and reading too much media and overlooking that their deposits are mostly, even overwhelmingly, insured. Investors and depositors need to chill. Such beliefs have consequences, including forcing banks to reduce lending to build more capital. That will contribute to a slower pace of growth, albeit only modestly so. Banning hedge funds from shorting bank stocks, which was reported as under consideration in Washington, is unlikely to be helpful and it’s a bad idea. Raising insurance coverage would be far better. But with the three most vulnerable bank basket cases now resolved, calm should return if no additional banks reignite the storm.
At this time, it appears that Fed officials would prefer to keep policy unchanged until the data reveals what they have accomplished and it becomes clear whether rates need to move higher or lower. Recession predictions have been around for more than a year now, with some forecasting a steep recession. Instead, growth has been very resilient and we expect it to remain so. Ongoing recoveries in housing, autos and civilian aircraft, reinforced by increased production of military equipment for Ukraine and other allies, and further reinforced by efforts to bring manufacturing back on shore will likely keep the expansion going. The inappropriately named Inflation Reduction Act will only add more spending to the mix.
While the pace of hiring has slowed, it remains well above a sustainable pace, especially since the cyclically low unemployment rate provides only limited incremental labor supply. The labor force participation rate for males between 16 and 64 (without a disability) has fully recovered to 82.5% and for females to 72.3%. Those 65 and above have shown little willingness to return to work and roughly 10,000 workers reach retirement age every day. This implied labor scarcity is likely to maintain upward pressure on labor costs, as Fed Chair Powell has warned. It is also why he worries inflation may moderate only slowly to meet their policy intentions. Even worse, they may not moderate much more at all. But that remains to be seen.
Market tensions may dissipate, if policy pauses, as appears most likely. The broad question of whether inflation can be brought to heel without a recession remains unresolved. A soft landing remains a difficult, unlikely outcome. But it is not out of the question. So, markets, the Fed and we must wait for data to uncover what the Fed has accomplished with its 5 percentage points of rate hikes. After the extreme excitement of three bank failures, we will welcome the respite, even if the path ahead is unclear. Welcome to summer (a bit early).
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