FOMC Preview: Inflation Battle Requires Fed to Dig in Deeper


Interactive Brokers’ Senior Economist

As painful inflation continues to pressure consumers and corporations, investors have become increasingly optimistic that this afternoon’s Federal Reserve meeting will show a central bank softening its war against price increases. This optimism is driven, in part, by the Federal Reserve (the Fed) already having increased the fed funds rate by 300 basis points (bps) alongside a $242 billion drawdown of the Fed’s balance sheet, a sharp contraction in the real estate market and significant slowdowns in manufacturing and consumption. Some global central banks, like in Australia and Canada, have dialed back their hawkish positions by delivering smaller rate hikes than expected, contributing to increasingly dovish sentiments. In my view, these developments, while to varying degrees are significant, pale in comparison to other factors that require the Fed to remain hawkish.

Markets had previously priced in 75 bps fed funds increases for this afternoon and in December, but that has changed to a coinflip for the December meeting, with 50% odds for either a 50 or a 75 bps hike. As optimism about the inflation war grows, some investors have become hopeful that the central bank won’t have to overshoot its rate hikes and instead drive the economy to a soft landing rather than a recession, but in my view the stubborn nature of decades-high inflation, entrenched in the highly inelastic services segments, makes that outcome unlikely.

Reasons for Optimism

First, the good news regarding inflation.

  • The real estate market, which is a powerful driver of economic growth, is contracting sharply. Housing starts for single-family homes dropped nearly 19% year over year (y/y) in September, while housing permits, mortgage applications and homebuilder sentiment have also been tanking. Many high-frequency measures of home and rent prices show declines. If these readings are sustained over the next several weeks and months, they would serve as powerful disinflationary forces.
  • The manufacturing sector is a whisker away from contraction territory, with a PMI reading of 50.4, its lowest reading since June of 2020 (anything under 50 shows contraction).
  • Consumption has been weakening, as higher interest rates and higher prices compel consumers to slow their spending. While consumer sentiment and personal savings remain in the tombs, credit card balances are in the heavens even as rates rise, pointing to burdened shoppers.
  • Commodity prices are declining, for the most part.

Trouble Ahead

Real estate weakness and the slowdown in manufacturing are encouraging on the inflationary front, but those developments are only scratching the surface, with the labor market continuing to be red hot. Unemployment is currently at 3.5%, its lowest rate in five decades while the number of job openings has increased since August despite the Fed’s rate increases, and today there are currently 1.9 job vacancies for every unemployed American, pointing to a labor shortage. This tight job market is likely to drive higher labor costs that businesses will pass on to consumers with price hikes and/or quality adjustments. Clearly, the Fed’s inflation battle and the slowdown in real estate, manufacturing and consumption hasn’t had a significant impact on labor, which argues for the Fed to remain hawkish.

The Gap between Job Openings and Unemployed Folks Remains Wide

The decline in commodity prices is also encouraging, but there are two sides of this coin. Oil prices rallied in October as OPEC made the decision to curtail production against the backdrop of already tight supplies and weak output. Food prices at home and at dining establishments have continued to pressure headline inflation due in large part to an inefficient commodity complex and labor shortages causing high wage growth for service workers. These higher prices will likely hamper progress within the food and energy categories in future data releases.

Following Three Consecutive Months of Declines, Crude Oil Prices Recovered in October

Even after three consecutive months of meaningful energy price declines, the Core PCE Price Index released last week shows that the Fed still faces a challenging inflation battle. The index climbed 5.1% y/y and 0.5 m/m in September, which was similar to August’s readings of 4.9% and 0.5%. The Fed’s inflation target on the Core PCE Price Index is 2%, which means that inflation is more than two and a half times above target.

Inflation Remains Significantly above the Fed's two percent target

With those points in mind, Fed Chairman Jerome Powell is likely to fly into November as a hawk, not a dove, and the aggressive actions required to curtail inflation are likely to result in a recession characterized by affordability pressures, declines in business investment and weakening asset prices. Lower asset prices are expected in response to the combination of softening demand and stubbornly high costs that will likely cause margin compression. Unemployment, however, is likely to remain benign due to job openings outnumbering unemployed folks.

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