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Main Point: The Federal Reserve is in one of the most difficult periods of the central bank's history. The Fed promised to continue raising rates until the 2% inflation target it met; or until they break something. Employment is one of the key metrics the Fed uses to gauge economic health. Positive employment numbers have given the Fed confidence to continue their path of tightening monetary conditions.
If the Fed continues tightening it will eventually put a strain on the economy and we will enter a deeper recession. Recessions typically hurt employment and lead to loss of jobs. The feds policy to fight inflation is in direct competition with their mandate to ensure full employment. If they do not get inflation back to 2% then the Fed's credibility will take a hit, which they cannot afford.
To summarize: If the Fed continues its policy of raising rates until the inflation target is met then we will enter a deeper recession early 2023. If the Fed is too soft in fighting inflation, the rise in prices will put serious pressure on households. The Fed can't win this battle because in order to save their credibility they have to continue rising rates; inevitably crashing the economy.
The FED Mandate
The Federal Reserve has stated mandate to ensure price stability and full employment. Generally the Fed maintains an orderly money market by providing liquidity to banks and other member institutions. Due to the recent crisis the Fed has made tackling inflation the priority. The problem with the contradicting mandates is that by fighting inflation the FED will send the economy into recession, damaging the full employment mandate. We can assume that the FED will continue to prioritize inflation until unemployment number reach 4.5-5%. At which point many economists believe the FED will pivot.
The Opposing Viewpoints (Fed Pivot vs. Tighter for Longer (TFL))
There are two mainstream opinions about how the Fed's policy will develop:
- Those that think the FED will pivot (change direction due to weakening economic conditions)
- Those that believe the FED will continue to tighten into the recession until they achieve 2% inflation.
FED Pivot:
The economists anticipating a FED pivot are under the assumption that current policy will lead to a recession. The recession will lead to a weakening of employment conditions which will signal the fed to change course; potentially reverting back to Q.E. (Quantitative Easing). This crowd insists that the pressure caused by high unemployment will be such a burden for the FED that it will cause a course reversal.
Tighter for Longer (TFL)
Federal Reserve chairman Jerome Powell indicated in his previous meeting that the FED was committed to fighting inflation and that it is willing to keep rates high until they hit the 2% inflation target. The FED has stated that inflation is the priority regardless of stock market behavior or economic pressure. This crowd believes that regardless of how bad the economy gets, the FED has to continue to tighten in order to save their credibility.
There is evidence to support both cases. The FED themselves have reiterated the TFL playbook. The Pivot crowd tends to believe that the FED is talking aggressively to scare the markets in the hopes that the economy will adjust without intervention. The pivot crowd believes that at the first sign of trouble (employment weakness) the FED will reverse course. The problem with the Fed's aggressive language is that they've set an expectation to tighten regardless of conditions, meaning they will continue to tighten into a recession.
Data to Watch
The FED is watching the headline unemployment rate as well as the ADP jobs reports to gauge the number of new jobs being added to the economy. Employment data and inflation prints are the most important metrics in this cycle. Some additional metrics include retail sales, consumer sentiment, and earnings. These metrics provide context relating to the health of American consumers.
Unemployment: Shows the FED when they've gone too far. A rise in unemployment will make the FED pause the tightening.
CPI/ PCE (Inflation): Shows the FED if their policy is working. The FED needs to see these numbers drop in order to relax their policy.
Sales/sentiment: Shows the strength of the American consumer, which is one of the most powerful economic forces in the world.
GDP: Gauges whether the economy is shrinking or expanding due to current policy.
Conclusion
The Federal reserve is on a dangerous path to fight rising prices. If they go too far they will send the U.S. (and global) economy into a deep recession. If the FED is too soft on tackling inflation then it will persist into 2023 and cause a larger shock to the economy.
We believe the Federal Reserve intends to get inflation under control but will soften their expectations on the inflation target of 2%. The FED is likely to tighten conditions until inflation drops from 9% down to 4-5%. At that point the unemployment situation will be weakening, forcing the fed to slow down the tightening and even reverse course to start printing again.
The FED can't tighten conditions forever. Eventually something in the economy will break and they will have to step in...the question is when? We believe the FED has another 5-8 months of tightening before the economic conditions worsen to the point of intervention. A deep recession is almost certain going into 2023.
Roy Dunia
October 10, 2022
Chartaddicts
Disclaimer: This article is the result of the analysis carried out by analysts associated with ChartAddicts. The article does not purport to represent the views or the official policy of ChartAddicts. This is not investment advice; please do your own research and consult a financial professional.