Source: Unweighted mean of measures from University of Michigan (mean) and Conference Board (mean), NY Fed (median, point estimate) included from June 2013
Third, it ignores the fact that inflationary pressures have now spread across the entire consumption basket. Nominal wage growth is far too high for comfort. Consumers and businesses have noticed the inflationary environment has changed. The pendulum may have swung a long way from labour to capital since the 1970s but the political momentum is now with workers. After scant gains in living standards since the 2008 crisis, workers won’t, in a strong labour market, resign themselves to ongoing real wage cuts. Central bankers reassure us that inflation expectations remain well anchored, but this isn’t what surveys of consumers and firms tell us (Figure 3).
Without a material economic downturn, inflation is very unlikely to fall back to target. But what matters for markets is whether the FOMC believes it will. And, therefore, how long the committee waits for data consistent with a persistent improvement in underlying inflation.
Whenever macroeconomic conditions deteriorate in 2023, the transitory inflation narrative will stage a comeback. But the FOMC has stated its intention to keep policy “at a restrictive level for some time.” As Powell said in November 2022, “History cautions strongly against prematurely loosening policy.”9 And we should not be surprised: across the suite of models employed by Fed staffers, most, if not all, are pointing to inflation well above 2% over the medium term.
In 2023, we will see whether a financial ecosystem sanitised by a decade of cheap money, and a deep-seated belief in the Fed put, is prepared for that moment when the US economy has gone into recession but the monetary cavalry is still some distance away.
An air pocket awaits, when the economic data is deteriorating fast (along with analysts’ earnings estimates) but before risk-free discount rates get any support from a Fed easing cycle.
A SLOOS AROUND THE MARKET’S NECK
The FOMC hiked the Fed Funds Rate by 425bps in 2022. Less than a year into a hiking cycle, it is unusual to be talking about an imminent recession. And the latest data suggests the US economy is humming along nicely, eg growth in non-farm payrolls of 250,000 per month in the fourth quarter of 2022. But Fed policy today works as much through signals of future policy intentions and management of its bloated balance sheet, as it does through changes in the Fed Funds Rate. A more holistic measure of Fed monetary policy (Figure 4) suggests policy started shifting in summer 2021, with dramatically larger cumulative effects on monetary conditions than a casual observer might perceive.
Gauging the pass-through to private sector credit availability – the next link in the chain – is always more art than science. Ephemeral forces, such as liquidity in financial markets, influence how forcefully central bank action bites. The orderly correction in asset prices in 2022 suggests that this pass-through has been limited to date. And, with a peak in the Fed hiking cycle expected soon, investors appear confident there is little more damage to be done. No wonder most expect the recession to be short and shallow.
That is one, optimistic, view. The other, more realistic, perspective is that there is a long and variable lag between policy tightening and any deterioration in credit conditions, and policy has only recently become restrictive, ie with the Fed Funds Rate above its neutral level.
Notably, the most reliable (and forward-looking) indicator of the credit cycle – the Fed’s Senior Loan Officer Opinion Survey (SLOOS) – shows lending standards tightening sharply (Figure 5). Indeed, by the time bank lending standards had tightened this far in past cycles, the US economy was already in recession.
Source: Unweighted mean of measures from University of Michigan (mean) and Conference Board (mean), NY Fed (median, point estimate) included from June 2013 9 Powell’s speech at the Brookings Institution, November 2022