The economic data released last week seems to tell a clear story: Consumer demand is falling, as evidenced by slowing retail sales. Wholesale prices were falling, indicating that further mitigation of inflation was on the horizon. The message seemed to be that the Fed’s tightening efforts were working, and stock markets initially rallied on the basis of the data.
But then, Fed officials hit the airwaves singing a different tune. Despite ample signs of an economic slowdown, they will remain steadfast in their pledge to raise interest rates in the coming months. “We still have some way to go,” said Loretta Mester, President of the Cleveland Federal Reserve Bank. The S&P 500 and Dow Jones Industrial Average fell. The declines extended into Friday.
This incident is perhaps the most telling example yet of the growing disconnect between Wall Street and the Federal Reserve over the most likely path forward for monetary policy. Markets have been watching inflation slowing over the past several months and eagerly awaiting the central bank’s turnaround, worried that continued tightening means an almost certain recession. But for the Fed, the welcome progress on inflation so far is simply in line with their expectations – and their forecast also suggests they still need to raise interest rates above 5%.
“The financial markets are like, ‘It’s cool, but it’s not cool.'” “It’s not tepid yet,” says Diane Swonk, chief economist at KPMG US. “They speak different languages, even though they talk about inflation.”
This divide is likely to persist, or even deepen, as long as the labor market remains tight and wage growth remains strong. While inflation has clearly peaked and parts of the economy are beginning to slow — two factors that bolster market optimism — Fed officials are focused hard on ensuring lower price growth in essential non-residential services sectors, before they can be convinced. Their efforts are working.
The Fed’s concern is that even as commodity prices deflate and housing costs slow, inflation will hit well below its 2% target, due to continued strength in those “super” services. Because of the way labor costs affect prices for services, Fed officials have focused on wages as a way to gauge whether their concerns are being realized.
Some market participants have questioned that approach, arguing that wages have been pushed up by Covid price shocks and will resolve on their own without the Fed forcing a rise in unemployment. Others took the recent advance in average hourly earnings in the December jobs report as a sign that the employment problem is abating, along with the broader economic cooling.
The Fed is not convinced. Other signs of anti-inflationary progress are simply decorating the windows until labor demand and supply are down again. “It’s one piece of the inflation puzzle that hasn’t been fully worked out yet,” says Anita Markowska, chief financial economist at Jefferies.
The longer the market discountes the importance the Fed attaches to wages, the harder the bank’s job becomes. By its own standards, the Fed has been fairly blunt about this, warning that any “undue easing” in financial markets in response to policy changes would complicate the path forward. If the tense economic data sparks a rally due to widespread expectations that the end of rate hikes is near, it could lead to somewhat the opposite result: further tightening, and thus, increasing the risk of a harder landing.
“The Fed can’t get the financial markets too far ahead right now,” says Sonck, adding that such a dynamic increases the likelihood of a premature economic revival. “They know what history tells them, and that is not a risk they are willing to take.”
The old slogan of “don’t fight the Fed” still rings true. But this time, because failure to recognize the central bank’s path forward could lead to worse repercussions for everyone.
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