The week ahead is going to be more interesting for monetary policy than it has in a long time.
The Federal Reserve, starting at the end of last month, said it would start delivering less forward guidance, preferring to follow data in setting its policy. And this week promises to be a Super Bowl of sorts for economic reports, which will challenge investors, economists and the Fed itself.
The outsized jobs gain in July, reported last Friday, nullifies a lot of evidence, including two straight quarters of GDP contraction, that showed the economy was slowing. Since the Fed is looking to cool inflation, if the economy is not weakening, this news could be viewed as a problem by some members of the policy-setting Federal Open Market Committee; some may look for additional, immediate measures if there is more unexpected news this week.
Raising the stakes
Fast job growth raises the stakes: Combined with rapidly increasing wages, it lays the base that suggests the economy won’t be slowing. Even though wages trail inflation, the wage and job gains will boost incomes and sustain consumer spending.
Productivity and unit labor cost data, on tap this week, may reveal declines in productivity and a surge in unit labor costs. Those wouldn’t be developments that would make the Fed happy about inflation — they would double the Fed’s need for good inflation news.
Expectations are set
Raising the stakes yet another notch is the fact that global commodity prices have been breaking lower, and that there is an expectation that inflation will fall this month. Because the unemployment rate dropped to a 50-year low, it’s even more important that the headline inflation numbers decline as expected and that core numbers behave.
The math behind inflation
The condition for inflation accelerating or decelerating is actually quite simple. Each month the year-over-year inflation rate consists of a string of 12 month-to-month inflation changes. Each month, 11 of those values are the same as the month before. The oldest of the 12 months drops off and a new month adds on.
The sole determinant of whether inflation accelerates year-over-year is whether the current July increase is greater or less than it was a year earlier. For this month, the year-ago headline number for the Consumer Price Index (CPI) was 0.5%. A gain larger than 0.5% would cause inflation to accelerate; anything less than 0.5% would cause a deceleration.
The core — which excises food and energy — is a different story. Core inflation in July 2021 rose by 0.3%. So the same acceleration-deceleration dynamic exists.
The Producer Price Index (PPI) is also scheduled. It’s a report of lesser importance. A year ago, July PPI rose by 0.9%, as the core jumped by 1.1%.
The jobs report changed everything
The strong jobs report put more importance on this week’s two inflation reports.
On top of that, the Fed’s next meeting stretches all the way to Sept. 20. If something in the inflation reports is intolerable, the Fed could do the unthinkable and call a special meeting to squeeze in another interest-rate hike. That would be a cruel blow to a market that had been hoping that the Fed might be close to making a pivot after epic rate increases.
Erroneous ‘pivot’ talk
The notion that the market had gotten about the Fed making a pivot to easier policy was probably another case of toned-down, but nonetheless irrational, exuberance. Chair Jerome Powell may have misspoken at the last meeting when he referred to the federal funds rate at 2.5% as being neutral. He did not mean neutral in the sense that the Fed didn’t need to raise rates anymore. He was only referring to the fact that 2.5% is the Fed’s view of the long-term neutral fed funds rate. But that applies only in the long run when the inflation rate is at the target pace of 2%. Clearly, with inflation running hot, 2.5% would not be construed as a neutral rate for policy at this time in this cycle.
Larry Summers and Fed Gov. Chris Waller have been at odds with one another over whether the economy can slow without a sharp rise in the unemployment rate or without creating a recession. And while the jury is out on this one, history has never seen the Fed crush high inflation by raising rates alone in a manner that did not create a recession.
That doesn’t make it an impossible job, but as the Fed tries to put the prospect of a soft landing on the table, we can see what this does to markets. It causes them to begin to look for the Fed to halt rate increases and pivot.
However, the big mistake that the Fed has made historically has been that it didn’t keep rates high long enough. This is now part of Summers’ warning. Every single recession the Fed has gone into since the late 1960s, it entered with the federal funds rate above the inflation rate. However, in some of those episodes, the Fed reduced inflation and in other episodes it did not. Most ominously in the nasty 1973-75 recession that mostly featured rising oil prices as well as an oil embargo, the recession ended with the inflation rate higher than when the recession began.
No precedent for policy
As the Fed looks to this cycle with inflation so far above the federal funds rate, clearly it has a different challenge. The tightening cycle has already begun at a disadvantage. The question for the Fed is going to be where it stops raising the fed funds rate because it clearly is not going to get that rate above the inflation rate the way it used to. We have little guidance on where the Fed will choose to put and keep the fed funds rate in this cycle.
A potential for fireworks
The outlook is confusing. Some think we will have a recession. Several FOMC members argue that the Fed can orchestrate a soft landing. Others are convinced that we have a period of stagflation ahead of us. Markets already have been wrong-footed once on the timing of a pivot.
Whatever we have ahead of us, it’s going to be something that is unprecedented because the Fed has never had to chase inflation from behind — the way it does now. And this might be the most difficult week of monetary-policy making since the days of Paul Volcker. If the inflation numbers come in as expected and show deceleration, the markets can probably breathe a sigh of relief. But in the event of more surprising strength of the sort that appeared in the jobs report last week, all bets for Fed policy are off. In that case, that Fed may find itself a stranger in a strange land with a difficult decision to make.
Robert Brusca is chief economist of FAO Economics.