Navigating the Crossroads

Navigating the Crossroads

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Strong Employment Data Complicates the Fed’s September Rate Decision

Without any doubt, the August employment report was quite strong, which presents a dilemma for the Fed at a crossroads. By itself, the data supports those pressing for a rate hike at the September meeting, but I don’t think it is forcing. So, a divided Fed has a decision to make, whether to convey to investors that it is truly committed to reducing inflation, or remain patient and risk losing credibility.

Inflation, Wage Growth and Productivity Divide the Fed

It is clear the Fed is divided, with several speaking about the need to hike rates, while others suggested they could wait a while longer. The fundamental disagreement is over whether inflation is moderating adequately and the latest jobs reporting fails to resolve the question. Hiring and economic growth are really good, suggesting a need to raise rates. But wage inflation is running about 3%, and it may be slowing slowly. But productivity is quite strong, running 1-1/2% to 2%. If those productivity gains are sustained, inflation should decline to the Fed’s 2% target and possibly even lower given some time. The wait is painful and frustrating, since actual inflation is still well above target.

What the Greenspan Era Could Tell Us About Today’s Fed

The current situation is reminiscent of the late 1990s, when growth and wage inflation were strong, but inflation remained muted. Many people expected the Fed to hike rates, including me. But Chairman Greenspan declined to do so. As I learned in a conversation with him when he was senior economic advisor to ACM some years later, his Fed staff also strongly recommended rate hikes. But it just didn’t feel right to him, so he kept waiting, while inflation remained benign. He acknowledged he didn’t have data to support his view. That episode earned him the moniker of “Maestro”, all based on gut feel. Only later did data revisions clarify what was actually happening. GDP estimates were revised higher, as was productivity. So, much of the acceleration in wage inflation was offset by larger gains in productivity, enabling inflation to remain well behaved. Another such episode could be taking place today, with AI boosting productivity. Warsh does not (yet) enjoy the credibility of Greenspan, so he is taking considerable reputation risk if he chooses to keep policy unchanged, productivity gains weaken and inflation picks up. Still, waiting is the correct strategy if those productivity gains keep coming. But you can be sure that Warsh will be criticized no matter which way he goes. Everything, including policy, has a political aspect to it these days.

The Fed’s Inflation Fight Reaches a Crossroads

Politics aside, the Fed will soon have to make a decision, whether to reinforce its credibility as inflation fighters and add teeth to Warsh’s promise to bring inflation back to 2% or keep policy unchanged to give inflation a chance to come down on its own. Either decision could prove mistaken, but only with the benefit of hindsight. After the latest employment report, investors lean slightly to a rate hike, but the upcoming inflation rate will push those odds and it may influence some votes within the Fed.

What the Economic Outlook Could Mean for Stocks and Bonds

Insofar as the markets are concerned, the economic data remains highly favorable for stocks and more ambiguous for bonds, especially longer-term bonds. The economy and corporate profits provide a very sound foundation for more stock market gains. The outlook for bonds is less clear, especially with the latest shooting events in the Middle East boosting crude prices. Nonetheless, as we understand it, more oil is getting out, far more than is officially reported. It is likely that the situation will remain volatile, but the solid foundation for stocks suggests that investors should avoid allowing themselves to be distracted by short-term events.

We think stocks are still attractive.