The latest Federal Reserve meeting minutes1 were released last week. Members pretty much completely agreed on the need for additional rate hikes2, virtually guaranteeing at least a 25-basis-point (.25%) increase at their next meeting on July 25 and 26. This, plus the jobs data last week (more below), cemented what the markets largely expected and have already priced in.
Now the worry will likely be how many more hikes we can expect before the Fed stops. Just like last summer, the talk of rate cuts by year-end has come and gone like a sudden summer afternoon thunderstorm. The market has priced in two more hikes on 25 basis points: one later this month and another in either September, late October or December. The latest consumer price index (CPI) and producer price index (PPI) numbers will be released this week, and if we don’t see significant improvement, talk will soon likely turn to the possibility of a third rate hike in 2023. We likely won’t see a meaningful drop in inflation this week, and with unemployment being where it is, the Fed may view that as a signal to keep going. But we’re also inching closer to the 2024 presidential election, and the Fed doesn’t seem to have the backbone to stand up to the political pressure of higher rates during campaign season. The risk of a policy error by the Fed seems to be increasing every day.
Markets have priced in two more hikes, a brief pause and then cuts. But what the markets have overlooked is the possibility of rates staying “higher for longer,” which is beginning to be a more likely possibility. That is the policy error we’re talking about; two or three 25-basis-point hikes are pretty minor when we are already at 5%. Why is “higher for longer” on the table? Because never have so many experts and analysts predicted an official contraction in the U.S. economy. The fact that “everyone” has predicted a recession for the past year virtually guarantees we will not have one, and the minute we start believing we have avoided a recession is probably when we will get one. The Fed could overplay its hand and may have to revert to panic rate-cutting mode because it will have gone too far and kept rates too high for too long.
On the other hand, for those who believe in the predictive power of the mighty Treasury market, it might be too soon to throw in the towel. The spread between the yields3 on the three-month Treasury bill and the 10-year note has had a perfect record of predicting US recessions with no false signals since the 1950s. I suppose if you keep saying we will get a recession sometime, you will eventually be proven right.
Jobs Keep the Fed Looking for an Oasis
Just like the thirsty desert wanderer looking for water, the Fed is drawn to a mirage it sees as an oasis in the inflationary landscape. Robust job growth continues to confound the Fed, and there aren’t any signs of letting up. But is the Fed looking at a mirage? The ADP national employment report4 last Thursday came in at a very strong +497,000, more than doubling the estimate of +228,000 and hitting the highest reading since February 2022.
according to ADP, job creation surged in June, led by consumer-facing services. Leisure and hospitality, trade and transportation, and education and health services all showed strong gains. Still, the market was fragmented, with manufacturing, information and finance showing declines. As a result, this pace of growth is likely not sustainable. Nearly half of the new jobs were in leisure; once people are done traveling and eating out, and credit card bills pile up, and higher interest rates weigh on those balances, guess what will happen? Airlines, hotels and restaurants will lay off those same workers. These are not “sticky” professional jobs.
On Friday, the Bureau of Labor Statistics (BLS) non-farm payrolls5 came in a little less robust than the ADP number. The BLS showed 209,000 jobs were added in June, with unemployment settling in at 3.6%. Expectations were for growth of 225,000 new jobs, so while ADP blew away expectations, the BLS number came in below consensus. Wages were up to 4.4%, barely keeping pace with current inflation levels.
The Fed will see this job growth not for the mirage it is (now is the appropriate time for the word “transitory”) but may be instead as a green light to combat inflation via higher interest rates. The problem is that once these mostly stop-gap jobs are no longer needed, the Fed will put us in a difficult position by having raised and keeping rates at a level that will hurt economic activity and hamper growth. The Fed is fixated on the jobs number and the unemployment rate, and they’re using the data as cover to justify raising rates. The problem is that these jobs can evaporate quickly like water in the desert, but the Fed will likely go too far before it realizes these jobs were just a mirage.