Fed Near End of Rate Hikes
The big news today was that payrolls increased by +261K. This caused markets to rally (shoot first, ask questions later). Interest rates moved up because the headline +261K may cause the Fed to be even more hawkish. Nevertheless, beneath the veneer, this was a very weak employment report.
There is something called the Birth/Death (B/D) model. Back before the turn of the century, politicians recognized that the BLS’s Payroll report was a survey of big business. But much of employment in the U.S. is done by small businesses. So, BLS, while it still doesn’t survey small businesses, adds a number, based on a time study. Of course, over time, as the economy grows, small business employment grows. However, in today’s economy, where we are likely already in Recession, small business isn’t likely to be growing; and we find that new business applications are steadily declining. So, there is good reason to be skeptical about the headline data.
Now for the end result – in October, BLS, via the B/D model, simply added +455K jobs to its survey. They weren’t counted. They were just added. Of note, this is the highest monthly adjustment in 22 years. Funny what you find when you do some digging. Since 2015, the Birth/Death add in October has risen every year from +165K in 2015 to +455K for this past October. Clearly, this is a time trend and has little to do with reality. We went back to the September data and stripped it of the B/D number and did the same for the October data. Then we subtracted one from the other. Turns out that, without the B/D numbers, the Payroll survey would have shown a fall of -366K.
We also should note that the unemployment rate rose from 3.5% to 3.7%. The Unemployment rate is taken from a different, but simultaneous, survey- the Household Survey. It fell -328K (that’s why the unemployment rate rose). And this is consistent with the Payroll Survey ex-B/D. Historically, while more volatile than the Payroll Survey, the Household Survey is a much more accurate indicator of the health of the economy.
BLS counts full-time and part-time jobs equally. So, if someone loses a full-time job and gets two part-time jobs to keep their income up, BLS counts that as +1 (a horrible methodology; part-time should be counted as 0.5). In the Household Survey, full-time positions fell -433K. That means part-time rose +105K. Over the last five months, part-time positions have risen by +628K while full-time positions have fallen -572K. This shows even more weakness in the labor market.
All-in, a full analysis shows that the Payroll gains were fueled by the great uncounted, i.e., the B/D model and a big shift from full-time to part-time employment. This is no reason to celebrate. Going forward, history shows that the November December and January B/D add for the Payroll Survey is quite low or even negative. That means the headline Payroll number should be more in line with reality. We expect it to be weak, especially since seasonal hiring intentions for the holidays in the retail sector have been quite weak as gleaned from Q3 earnings reports.
On Wednesday, the Fed raised interest rates by 75 basis points (3/4 of a percentage point). Rates are now at 3.75-4.00%, well above the neutral rate of 2.5%. Let’s pause here to discuss the relatively new “Fed transparency.” Prior to the Bernanke era, the Fed and its FOMC members and Governors never made public statements. All the markets knew was what the Fed had done to interest rates. In 2012, the Fed became “transparent,” telling the financial markets, via the dot-plot and public statements by the FOMC members, what the Fed’s intentions were. In this new era, the fixed-income markets almost immediately move interest rates to where the Fed signals will be the “terminal rate.” Since 2012, this is the first real extended tightening cycle, so the nuances of “transparency” have yet to fully play out. The first Fed move came on October 21st when the Fed leaked its intention to begin to step interest rates down.
On the last day of the Fed meeting, there is a two-step process. The first step is the release of a written statement. The second step is the press conference. On Wednesday (November 2nd) when the written statement came out, but before the press conference, the financial markets rallied (both stocks and bonds). That was because the Fed’s statement said that in the future they will be considering “the lags with which monetary policy affects economic activity and inflation…” That implies future rate hikes won’t be as large as 75 basis points and that we may be approaching the end of such hikes altogether. Remember, in the era of “transparency,” financial markets immediately move to the Fed’s “terminal” rate which now appeared to be lower. That was not what the Fed wanted – they don’t want markets to ease financial conditions. (Remember, in the pre-Bernanke days, there was no statement or press conference, so the markets didn’t know anything about Fed intentions.) As a result, this is the first time that Fed officials (mainly Chairman Powell) have had to manage market expectations. To reiterate, markets were moving interest rates lower because of the Fed’s statement acknowledgment that they would be considering the lagged impact of past rate increases, market jargon for a lower terminal rate. So, during the press conference, Powell was quite hawkish saying that “the ultimate level of interest rates will be higher than we previously thought” which implies that December’s dot-plot will be higher than September’s (the latest one). Whether that occurs or not remains to be seen, but that statement accomplished his purpose as the financial markets gave up their gains. Thus, it appears that in this era of “transparency,” managing the yield curve is much more difficult than in the “non-transparent” era.
In the end, what we know is that future rate hikes will be less than 75 bps (maybe 50 or even 25 at the December meeting depending on the incoming data), but that the time period for high rates is still lengthy – i.e., a rate cut is not yet on the horizon. . Ultimately, the Fed accomplished its goal of signaling a slowdown in rate hikes without having the markets move rates down and ease financial conditions. As you can see, the era of “transparency” is much more nuanced than the era of no communication, and managing market expectations and reactions is now an additional task for the Fed’s Chair and the FOMC members.
- During the Fed’s press conference, Chairman Powell alluded to the fact that the economy is still quite strong, noting that consumers have a stash of savings that will carry them through the economic slowdown. We find that the facts don’t match that statement. In the charts, note that consumer credit has skyrocketed as consumers try to deal with high food and fuel prices. In addition, the savings rate has plummeted to its lowest level in more than a decade. Clearly, from the point of view of those items, the U.S. consumer is hurting. Of course, politically, the Fed can’t say they are causing a Recession, but they know they are!
- Data from the Fed’s own Regional Bank surveys shows that businesses are now contracting, not expanding. The following table shows the data from the latest Fed surveys (zero is the demarcation line between expansion and contraction). Only Philadelphia’s was slightly better, but still deeply negative. Shipments and new orders were negative. On the positive side, the inflation metrics were promising: Backlogs and Supplier Delivery Delays were back to pre-Covid levels. Hiring, CAPEX, and wage plans were at their lowest levels since 2020, and the six-month “expectations” index weakened.
- Used vehicle prices have been a poster child for the rapid rise in inflation. A primary reason for the rapid rise in used-car prices was the inability of U.S. auto manufacturers to get the chips needed to produce new vehicles. The result was an increased demand for the used ones. But, over the past few months, oh how things have changed! The chart at the top of this blog shows the Y/Y percentage change in used car prices, now down more than 10% and likely still a lot further to go.
- All the Fed surveys indicate that supplier delivery delays are back to pre-Covid levels. The following two charts show the high correlation between supplier delivery delays and goods inflation (left-hand chart) and shipping rates (right-hand chart). This is good news for inflation going forward.
- The toughest inflation issue is and has been, rents. With a plethora of new apartments now coming online, rents in the private sector have already begun to fall. One of the issues is the way the Commerce Department calculates rental inflation. As seen from the chart below, private sector measures show falling rents. The CPI calculation is highly correlated but just lags by a few months. The chart shows that, if the correlation holds, the CPI measure will begin to fall early in 2023.
Housing is a mainstay of economic growth. As we have chronicled in these blogs, it is the most interest-sensitive sector and thus the first to be impacted by rising interest rates. We note that even in the Payroll Survey, there were scarcely any new jobs for construction workers. The chart shows why, i.e., new construction is falling hard (left-hand chart). Noteworthy is that sales of new homes have fallen by more than -30% since July as 30-year fixed mortgage rates have topped 7%. The chart on the right shows how far and how fast mortgage purchase applications have plummeted.
But that’s not all. Refi applications continue to fall, now down -85% Y/Y. Just think about that. An existing homeowner with a 3%-4% mortgage rate isn’t going to refinance the whole mortgage to get cash to buy a car or go on vacation, or even fix up the existing house. In fact, what we see happening is that home improvement stores are seeing higher sales, as homeowners decide to fix up what they have instead of selling and taking on much higher mortgage payments. In the end, this slows economic activity.
As we have indicated in past blogs, we think that the rate of inflation will come down faster than the markets or the Fed currently believes. The latest data we have for home prices is in August, the Cash-Shiller Index showed the steepest one-month decline since March ’09. It is now November. The downbeat data in the housing sector make it a certainty that price declines have continued in September and October. Home prices in Canada have fallen 17% since February. Something similar is likely to happen in the U.S. In addition, consumer credit balances have skyrocketed. That means that consumption growth will be nil going forward. We saw that in the Q3 GDP data where final sales to private domestic purchasers were flat vs. Q2.
As discussed, the Fed has now announced that future rate hikes will be smaller, and we believe that we are closer to a “pause” and then a “pivot” than many think. The world’s other central banks (ECB, RBA) have said “enough” and China’s PBOC and Japan’s BoJ never did join the rate-raising fray. Of course, it all depends on the incoming data. We see that data as getting weaker.
Robert Barone, Ph.D.
(Joshua Barone contributed to this blog)