Is The Fed Changing Its Tone?

As most observers expected, the Federal Reserve raised its benchmark lending rate by 25 basis points to a range of 4.5% to 4.75%. The central bank also said it will continue reducing its holdings of Treasurys and other debt like mortgage-backed securities.

In other words, it’s mostly more of the same story we’re used to, just with a slower pace of hikes than the 75-basis-point jumps we saw last year. No less importantly, the Fed is changing its tone.

Fed officials seem increasingly leery of doing too much more before seeing what impact the hikes have on the economy.

So far, the Fed-induced economic slowdown has been more of a slow burn. Headline inflation numbers have eased since the summer, and the jobs market hasn’t weakened significantly yet outside of layoffs at big tech companies. The economy hasn’t crashed.

On the one hand, in a statement, the central bank’s Federal Open Market Committee (“FOMC”) said the same thing it has for months…

The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.

On the other hand, that same statement omitted a few key phrases that it has included after recent policy decisions. No longer does the Fed think the inflation numbers reflect “supply and demand imbalances related to the pandemic” or that the war in Ukraine is contributing to inflation.

And the central bank said for the first time that inflation has “eased somewhat.” It said the big question is no longer what the “pace” of rate hikes will be, but the “extent” of them. To me, that means a regular ol’ 0.25% hike or nothing until further notice.

In a post-announcement press conference, Powell cautioned against anyone taking this as a sign that the central bank thinks it already solved inflation. “The job is not fully done,” Powell said, rephrasing a line he made last August in Jackson Hole, Wyoming.

But he also said that “we think we’ve covered a lot of ground” with rate hikes, and that the “disinflationary process that you see is really at an early stage,” implying the lag effects of policy haven’t hit most of the economy yet and there’s “no incentive to overtighten.”

Reading between the lines, the Fed is softening the aggressive tightening stance we’ve seen for about 12 months. Mr. Market thought so, too. The benchmark S&P 500 Index reversed from a nearly 1% loss before Powell started speaking to a roughly 1% gain by the close.

Just before the Fed announcement, we saw an interesting note out of the jobs market. The Labor Department’s latest data showed that job openings in the U.S. rose to 11 million in December, the highest amount in five months.

That’s about 1.9 openings for every job seeker, close to an all-time high…

This means the jobs market is still tight which encourages pay increases. That’s not a bad thing for everyday people, but it’s not what the Fed wants to see to ease inflation.

Higher wages mean more costs for businesses, which they’ll pass on to consumers. At the press conference, Powell downplayed the latest data, saying it has been “volatile.”

Probably more important, wage growth is substantial right now. Wages rose 7.3% year over year in January, the same rate as December, according to payroll company Automatic Data Processing (ADP). And workers who switched jobs saw a median increase of 15.4%.

Still, other numbers from the U.S. Bureau of Labor Statistics paint a more promising picture. They suggest that the “cost of an employee per hour spent working” (including the cost of worker benefits) is growing at a slower pace than previous highs. Year-over-year growth for the fourth quarter of 2022 was only around 1%, below the Fed’s inflation target.

The ECI also has tracked widely followed headline inflation numbers by comparing this measure with the consumer price index (“CPI”) and core personal consumption expenditures (“PCE”) index, the Fed’s preferred inflation gauge.

Both of these charts are pointing to a noticeable trend shift in labor costs. Granted, they’re not imploding but the pace of gains is slowing. And as we can see, that change tracks closely with the different inflation gauges. Consequently, they’re easing as well.

However, this measure would still need to fall in half just to get back close to “normal” levels. There’s a way to go to get there.

The pace of headline inflation may be slowing down from record highs, and worker costs are easing, too. But as long as the jobs market remains tight and pay keeps rising to attract workers, the Fed likely won’t have much reason to “pivot” and start cutting interest rates to help the economy anytime soon.

If anything, a super-strong labor market without an obvious recession (meaning one talked about in the mainstream media) favors the status quo. That means the Fed would need to make further small rate hikes – or, at the very least, hold rates around their 5% target until further notice – to make dollars more “expensive” and cool the economy more.

Remember, a lot of folks either retired or left the workforce for various reasons during the pandemic and aren’t coming back. At least not yet.