Throughout 2022, the biggest focus in financial markets was the path of Federal Reserve (Fed) policy in its fight against high inflation. Now that the calendar has turned over to 2023, the focus has shifted to the paths of economic growth and inflation. This change has been fueled by Fed messaging that large-scale rate hikes are behind us, coupled with an expressed desire to remain data-dependent while in restrictive territory.
To begin this year, the market has gravitated toward pricing in a soft-landing scenario, where inflation moves down rapidly and growth does not slow enough for the economy to enter a recession. In this Chart of the Week article, I will discuss how we’ve gotten here and the risks to this view.
Around this time last year, when the Fed was just starting its current tightening cycle, Chair Jerome Powell expressed confidence in the ability to engineer a soft landing. As time went on, this confidence slowly wavered, with the language moving from soft to “softish” to an acknowledgment that some pain will likely be necessary.
However, last week at the Federal Open Market Committee (FOMC) meeting, Powell expressed renewed confidence in the possibility of engineering a soft landing.1 The market seems to back this confidence, as the start of this year has been marked by a rally in risk assets across the board. It seems prudent to discuss what is fueling this sense of confidence.
In order to achieve a soft landing, both a cooling in inflation and a mild deceleration in growth are needed. Essentially, restrictive monetary policy needs to do its job without causing sharp economic contraction. On the inflation front, the Consumer Price Index (CPI) has been declining each month since peaking in June 2022.2 This decline has been led by cooling energy, food and goods prices.
Even more encouraging is the fact that Core CPI, which strips out volatile food and energy prices, hit a peak in September 2022 and has since been on the decline.3 We have also seen the Employment Cost Index decreasing, indicating that wages are not increasing fast enough to keep inflation sticky.
On the growth front, quarterly growth in U.S. real GDP has rebounded from two consecutive negative prints in March and June of last year, and has been in positive territory for the past two quarters.4 Additionally, the Institute for Supply Management’s Services Purchasing Managers’ Index (PMI) points to strength in this sector of the economy.
For the Services PMI, a reading above 50 indicates expansionary conditions while a reading below 50 indicates contractionary conditions. The index was able to remain above 50 for 30 consecutive months until dipping to 49.6% in December 2022, only to sharply rebound back into expansionary territory for January 2023 with a reading of 55.2%.5
In conjunction with this development, the labor market remains strong. Last week, the nonfarm payrolls report blew expectations out of the water, showing the economy added 517,000 jobs in January, against expectations of 188,000. Along with this print, the unemployment rate declined to 3.4%, although labor-force participation was up for the month.6
On top of all these positive U.S. developments, global growth prospects have also been improving. Due to an unseasonably warm winter, Europe was able to avoid the severe energy crunch that was predicted for much of last year. In Asia, meanwhile, the reopening of China has been a long-awaited positive development.
With the rosy picture painted by the above data, the market has priced in a fairly different scenario for Fed policy than the FOMC projected in the December Summary of Economic Projections (SEP). This week’s Chart of the Week shows the current path of the Fed funds rate implied by futures pricing. The market is pricing in a rapid deceleration in inflation, coupled with roughly 200 basis points of rate cuts beginning in November 2023. This contrasts sharply with the SEP, which shows inflation cooling more slowly and the Fed reaching a terminal rate of 5.1%, and then pausing there until 2024.
This week’s article wouldn’t be complete without highlighting some of the risks to the current optimism being priced into financial markets. On the inflation front, the Fed has expressed a need to make progress on Core Services ex. Housing Personal Consumption Expenditures (PCE) in order to meet its 2% inflation mandate.
Over the past three months, there has been no progress in cooling this category. Further compounding the difficulty in taming services inflation, the ISM Services Prices Paid index continues to remain elevated. This leaves open the possibility that service providers will need to pass on increasing costs to consumers.
Additionally, the Fed has expressed that Core Services ex. Housing PCE is tied to slack in the economy. From this lens, a hot labor market is not desirable. Last week’s data release was initially met with a sharp selloff in risk assets. Chair Powell also expressed during his press conference that he expects goods disinflation to abate soon, forecasting that goods prices will eventually remain flat on a monthly basis and add some stickiness to inflation in coming months.
Lastly, when looking at economic growth moving forward, the manufacturing sector stands in contrast to the hot services sector. The ISM Manufacturing PMI has been in freefall since early last year, and has now remained in contractionary territory since November.
Market pricing to start 2023 has pointed to an optimistic outlook for the year ahead. Risk assets have rallied sharply in the hope there will be a soft landing. While the odds of a soft landing have surely increased, there are still risks to this view.
Current market pricing indicates that inflation will cool rapidly and the Fed will be quick to ease financial conditions. On the growth front, the manufacturing and services industries are painting contrasting pictures. However, a strong labor market points toward growth prospects being good and the economy continuing to run hot.
While inflation is cooling, there is evidence it may eventually become sticky above the Fed’s target level. If the economy can remain strong, the Fed will have little incentive to cut rates in this scenario. A strong economy coupled with high rates will also raise the question of whether the neutral Fed funds rate is higher than previously thought.
Even in a scenario where growth does slow, the Fed will not have much incentive to cut rates if inflation is outside of its target range and growth contraction isn’t sharp. With this in mind, the current Fed funds rate path priced in by the market seems to be fairly optimistic. This optimism may spell trouble for risk assets if the outlined risks materialize and rate cuts are priced out of the market.
1Source: Reuters- Fed's Powell: Prospect of U.S. Soft Landing Remains Alive; 2/1/23
2Source: U.S. Bureau of Labor Statistics- Consumer Price Index; as of 2/7/23
3Source: Fred- Consumer Price Index: All Items Excluding Food and Energy for the United States; as of 2/7/23
4Source: Fred- Real Gross Domestic Product; as of 2/7/23
5Source: Trading Economics- United States Services PMI; as of 2/7/23
6Source: U.S. Bureau of Labor Statistics- Employment Situation Summary; 2/3/23
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