The old saying is that “talk is cheap.” It certainly isn’t if you’re a central banker. Investors hang on a central banker’s every word. Whether the Federal Reserve (Fed) hikes by 75 basis points (bps; 100 bps equal 1.00%) or 50 bps is probably less relevant than what Fed officials say with their Summary of Economic Projections (their guesses about what they’ll do in the future and how the economy may evolve).

The last couple of times that the Fed hiked by 75 bps, Fed Chair Jerome Powell said those types of large moves were unusual. Well, the unusual seems to have now become usual or routine. We think it’s likely we’ll see another unusually large increase in the federal funds rate at the Federal Open Market Committee meeting on September 21, but it will likely be the last unusually large move.

What data have come in since the Fed’s last meeting that tip the scales in favor of a 75-bp move?

  • July payrolls expanded by 526,000. August’s expanded by 315,000. In August, the labor force expanded, which was encouraging. It suggests there may be more “slack” in the labor market than what the very low unemployment rate suggests, which in turn could mean that wage growth won’t feed into future inflation.
  • Consumer price inflation decelerated to 8.5% year over year in July with the monthly inflation flat due to falling energy prices. August’s inflation was 8.3%, a bit stronger than many expected but at least heading in the right direction.
  • Retail sales excluding autos and gas rose a solid 0.3% month over month in July and another 0.3% in August.
  • Manufacturing activity in July rose a solid 0.6% month over month and then 0.1% in August.
  • Surveys of purchasing managers pointed toward continued economic growth and falling price pressure.

The totality of the data indicates growth is decent and inflation is moving in the right direction. What’s not to like? The Fed could probably get away with a smaller rate hike, but since the market seems to be already pricing in a 75-bp hike, why not take what the market is willing to give?

Thus far, the Fed’s actions have met market expectations, but Fed officials have been trying to push against the idea that they might hike and then cut at the sign of any economic weakness. The Fed, however, has been insisting that it wants to hike and hold. This is where the Summary of Economic Projections comes into play.

In June, when the Fed last updated these guesses, the median projections were that the unemployment rate would rise to 4.0% over the long term, inflation would drop to 2.6% in 2023 and drift to 2.0% over the long term, and the federal funds rate would be 3.8% at the end of 2023 and eventually move to 2.5% over the long term. All of these numbers are up for grabs.

Any changes in the Summary of Economic Projections will show just how much pain the Fed is willing to inflict on the economy in its effort to anchor that long-term inflation number at 2%. The risk is that the Fed tries to signal that it’s too serious about hiking and too sanguine about the potential effects of inducing an economic slowdown to tame inflation.

In the current situation, though, an economic slowdown might not be accompanied by the usual increase in the unemployment rate that you’d expect based on past economic slowdowns. Businesses may be so scarred from the struggle of finding workers to fill vacancies during the COVID-19 recovery that they may be loath to lay them off during any slowdown or recession.

Employment is a lagging economic indicator, so to keep employment reasonably strong, the Fed will have to look at a whole mosaic of other indicators to see when rate hikes have been pushed too far. Thus far, housing has cracked, auto sales have declined, and consumers have been trading down in order to focus on buying essentials instead of discretionary items in the face of higher prices.

When navigating an environment like this one, we like how those who hold cash aren’t being punished—at least in nominal terms. However, we’re still cautious when it comes to fixed income and equities. The Fed might not be the last to know that it has gone too far with rate hikes, but it might be the last to care—at least, relative to investors.

 

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