A Gradual Shift Begins, Supply-Chain Challenges Remain
Policy normalization appears to have begun for the Federal Reserve and some of the largest foreign central banks, but economic challenges remain.
The gradual shift to policy normalization appears to have begun for the Federal Reserve and some of the largest foreign central banks. The Sept. 22 FOMC official statement signaled that a November taper announcement is likely, and the updated Summary of Economic Projections (SEP) revealed a growing rift within committee participants related to the timing and aggressiveness of future rate hikes (more on that below). The European Central Bank and Bank of England followed with somewhat hawkish rhetoric as well, referencing worries over potentially “sticky” inflation. Financial markets have also been giving attention to China’s economy and the likely failure of real estate giant Evergrande, looking for any signs of more systemic fallout. The budget debate in Congress also remains front and center with President Biden signing legislation on Oct. 14 temporarily raising the government’s borrowing limit to $28.9 trillion, pushing off the deadline for debt default only until December.
Senate Republicans blocked House-passed legislation on Sept. 27 that would have funded the government into December and suspended the debt ceiling until the following December, after mid-term congressional elections. Republicans prefer to separate the debt ceiling suspension from the government funding legislation so that the former could be used as a negotiating tool in Democrats’ larger $3.5 trillion budget reconciliation plan. Congress was able to pass short-term legislation to fund the government through early December, but the debt ceiling still looms. A technical default would obviously be a dangerous scenario, and although we have witnessed multiple debt ceiling standoffs over the last decade, even a remote possibility of a U.S. default still fosters some investor consternation, particularly from overseas buyers.
A Growing Divide
The September FOMC meeting was much anticipated for multiple reasons. First, Fed Chair Powell’s Jackson Hole speech made clear that any upcoming meeting was “live” for a taper announcement, and while there was some possibility for a September announcement, the general expectation was for the committee to telegraph a decision at the next meeting (November). They did just that with both the official statement and Powell’s press conference, but Powell did offer a modest surprise when he suggested that tapering would wrap up by the middle of next year. That would imply a $15 billion per month pace ($10 billion Treasury/$5 billion MBS) as opposed to the $10 billion per month pace that many were expecting.
The second, but not less, anticipated item of the September FOMC meeting was the updated quarterly SEP. This version would provide the first look into 2024 forecasts of the committee, particularly participants’ interest rate forecast “dots.” Over the last several weeks leading up to the meeting, many of the regional bank presidents had made more hawkish comments, particularly related to the timing and pace of asset purchase tapering. The Fed Dot Plot graphic above provides a breakdown of the Sept. 22 “dot plot.” The median forecast now shows a rate hike in 2022, but the committee was split 9-9 on whether a hike would be appropriate. As you move into 2023 and 2024, the dispersion of individual forecasts becomes much more pronounced. For 2023, there is a 150 basis point difference between the high and low forecasted rate. For 2024, the dispersion expands to 200 bps.
Given the growing divide of participant opinions, it’s worth noting the voting procedures for the FOMC. The FOMC consists permanently of the seven members of the board of governors, as well as the president of the New York Fed. Four of the remaining 11 regional Fed bank presidents serve one-year terms on a rotating basis. There is still one open seat on the board of governors, but assuming the governors and New York Fed president vote together, even the most hawkish regional Fed presidents would be outnumbered 7-4. In other words, assuming that the dots at the top end of the range are representative of the more hawkish regional Fed presidents (and not the governors), then the median forecast is overstating what the “core” of the voting members are currently expecting. The market understands this well, and following the release of the September SEP, the overnight index swap and Fed funds futures markets are pricing the effective Fed funds rate 45-65 bps below the new median Fed forecast for 2024 year-end.
Delta Variant, Supply Chain and Labor Tightness
Looking ahead, Delta variant headwinds have largely faded from a market perspective, with new COVID hospitalizations steadily declining since their peak in August according to CDC data. China is still on the radar, but its central bank recently told downstream banks to support local developers and homebuyers to offset fallout in the housing sector from the Evergrande debt crisis. Supply-chain challenges remain stubbornly persistent in the goods sector as the global economy reopens and shipping containers run into bottlenecks at major U.S. and overseas ports. These issues have contributed to high inflation readings over the last several months, and Fed Chair Powell recently acknowledged that this spell of higher inflation may last longer than he and his Fed colleagues had initially anticipated. The supply chain issues have particularly affected the auto sector in the form of chip shortages, which have clearly impacted new car production and sales. Reduced production and plunging inventories have contributed to four straight monthly declines in unit sales through August, leaving many economists to temper their Q3 GDP forecasts.
The labor market continues to tighten as job openings remain historically high relative to the number of hires. The second graphic above tracks the job openings to hires ratio, which is a common proxy for labor market tightness, as well as the quit rate, which also typically rises in stronger job markets. The openings/hires ratio continues to set new highs (records began December 2000) and wage inflation will be an important metric to watch going forward, as it can fuel stickier, more persistent inflation. Regarding the large number of job openings, part of the problem may be attributable to the migration from services to goods consumption over the life of the recovery, leaving goods producers understaffed to meet increased demand. If the service sector recovery stalls, some of these workers might have to transition to the goods sector.
Jason Haley Chief Investment Officer ALM First Dallas