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  • Writer's pictureJonathan Wilmot


Members of the FOMC have made significant policy speeches since the last FOMC. If we had to make a one line summary, it would be that the Fed doesn’t really care that much about when inflation peaks (it probably has already) but it does cares a lot about where inflation will settle. And on that score there is plenty of room for different opinions. More specifically, that means there is not much certainty, and therefore no real consensus, on just how high policy rates need to go to ensure that inflation settles back near the Fed’s 2% goal. That fits what Jay Powell had to say towards the end of his press conference on November 3rd: "I would also say it's premature to discuss pausing. And it's not something that we're thinking about, that's really not a conversation to be had now. We have a ways to go. And the last thing I'll say is that I would want people to understand our commitment to getting this done. And to not making the mistake of not doing enough or the mistake of withdrawing our strong policy and doing that too soon. So those, I control those messages and that's my job. Leaving aside the fact that nearly everyone on the FOMC is thinking about when and where the Fed might pause, the point is that there is no consensus on that yet, whereas everybody agrees that policy is not yet restrictive enough. If there is a common view, it is now that policy rates will need to go to at least 5 %, and perhaps considerably higher. As so often, James Bullard has tried to put that into a more analytical context. First, he contests the notion that inflation can only come back down to target via a big loosening of the labour market (aka recession). He suggests that the mechanism of disinflation can run from lower demand to lower profit margins even without a big rise in unemployment. That is a relatively bullish message for equities in the following sense: the absolute level of profits can in theory hold up pretty well if revenues keep growing even if margins are shrinking. But if margins are shrinking and revenues are falling (the norm during recessions) that is a much more bearish story for corporate earnings.

In his most recent speech Bullard tries to put a frame around the uncertainty about how restrictive the Fed needs to be. He contrasts two different Taylor Rule specifications - one of which runs on what he calls “optimistic" assumptions, the other on “pessimistic” assumptions, and comes up with a projected range of 5 -7% for the terminal Funds Rate. No spread too wide you might say! Strangely enough the Fed funds futures market isn’t really buying it - or at least not yet. It’s still pricing in a longish plateau for the Fed Funds rate around 5%, which taken literally means that they are putting a near 100% percent probability on Bullard’s optimistic scenario. Indeed if you look at how pricing has changed since mid-October the projected peak Funds rate is marginally higher but the longer-term contracts are priced marginally lower.

The structurally tight labour market thesis implies that a big re-pricing is coming, (down in price, up in implied yield) unless the economy falls off a cliff around Xmas. (It certainly isn’t doing that now: the Atlanta Fed’s GDP Now tracker for the current quarter is running over 4% per annum). And the primary trends of the current year (Bonds down, stocks down, the dollar up) will likely resume with a vengeance if FF futures market moves to pricing in a terminal rate nearer 6% than 5%. Our view is that what happens to wages and thus to core service sector inflation depends more on what happens to energy prices from here than on the precise level of labour market slack. More on that shortly but as a teaser here are two charts to ponder.

What they say is that in times of war, nominal wages jump but real wages trend down, even when you deflate them by the PCE deflator rather than the CPI-W as the BLS (inappropriately) does. A surge in nominal wages combined with a (slight) fall in real wages is pretty much what is happening now. Or to put it slightly more accurately, most workers are finding that the only way they can achieve a (small) rise in real wages is to move jobs, and those who aren’t moving are suffering a small fall in real wages. On average, however, real wages are slightly down despite the “red-hot” labour market.


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