Ajay Rajadhyaksha is the Global Research Chair at Barclays.
Financial markets trade on stories. And over the past few weeks, the dominant story in bond and equity markets has been that the Fed will pivot, and soon. Investors expect a rapidly weakening economy to force the U.S. central bank to turn around and cut rates just months after the hikes end.
This belief gained momentum in July, with many investors suggesting the Fed could signal a change when it retreats to Jackson Hole in late August. Every weak housing data point fueled this narrative; each contraction of the PMI has brought grist to the mill. A sharp decline in commodity prices, a slump in business and consumer confidence, a drop in market expectations for inflation over the next decade – all pointing in the same direction. And then there was the story: the Fed flip-flopped in the last two bull cycles. The increases of summer 2007 gave way to cuts in 2008. And memorably, the Fed rose in December 2018 only to reverse course in January 2019. It’s no wonder markets waited for the US central bank signals a change again.
Easier said than done.
The most important data – inflation and wages – are still too strong for the US central bank to breathe easy. Much too strong. And the numbers are accelerating, even ahead of July’s strong jobs report. Consider the latest inflation print. Core CPI (which excludes food and energy prices) over 6 months is moving at an annualized rate of nearly 7%. But the rate over 3 months is almost 8%. And the 1-month annualized number is almost 9%. That means core CPI is picking up, not slowing, and is in a very different zip code from the Fed’s 2% target.
The evolution of wages is even more important. In recent months, it appeared that wage growth was slowing. Average hourly earnings, shown in the monthly jobs report, appear to have stabilized at an annual rate of 3.5-4%. Then three things happened at the same time. First, the Atlanta Fed’s wage growth tracker showed that wages accelerated sharply in June (6.7% annually):
Second, data on average hourly earnings have been revised upwards. Lo and behold, salaries are no longer slowing down in this series.
But most important was the latest release of the Employment Cost Index (ECI), the Fed’s preferred indicator. Private sector wages accelerated sharply to reach an annualized rate of 6.5% in June. The icing on the cake, of course, is that the unemployment rate hit a post-Covid low last week. The American labor market is not only not to slow down. It’s accelerating.
It is true that labor markets are notoriously backward-looking. In September 2008, at the time of the financial crisis, the unemployment rate was still 6.1%. When it peaked at 9.9% a year and a half later, the United States was well on its way to recovery. Even so, Fed officials care deeply about wages. If high wage expectations embed themselves in an economy, high inflation can stay “sticky” much longer. A 2% inflation target is hard to achieve if per capita wages rise 6% in 2023. Central bankers don’t like to admit it, but one of the main purposes of rate hikes is to cause enough job losses to ensure that wage growth slows. And if that doesn’t happen despite several rate hikes, it adds pressure on the central bank to raise rates further and keep them high for longer.
Admittedly, monetary policy operates with a long and variable lag. This is why the decisions of central banks are most often based on forecasts; today’s data is not meant to be the dominant driver of today’s politics. But these are not normal times. The spike in inflation over the past 12-15 months has been massive, persistent and defied forecasts. And one by one, central banks have had to adjust their policy to incoming inflation data. The Fed broke its own forward guidance and hiked 75 basis points in June on a strong CPI report in May. And the ECB followed in July, rising 50bp despite the 25bp promise.
Strong jobs reports are generally greeted enthusiastically in the Marriner S Eccles building. But the starting point on inflation, including core inflation, is just too high. Markets got ahead expecting the Fed to start adopting a more dovish stance. As it stands, any surprises from the Fed over the next few months are more likely to be hawkish. Investors expecting an imminent pivot will have to keep waiting.