Both Sides Now: Fed’s Dueling Mandates
It's uncomfortably hot in much of the country; perhaps an apt way to describe last Friday's employment report for July. As a reminder, the labor market is one of the two mandates of Federal Reserve policy decisions. Given the still-hot labor market, and still-hot inflation, the Fed's dual mandate may be better described as dueling mandates.
July's headline payrolls were much stronger than expected at 528k vs. the consensus expectation of 250k. Not a single economist as part of the consensus had a number anywhere near that high. In addition, there were positive revisions to the prior two months to the tune of an additional 28k jobs. As a result, payrolls have finally surpassed their pre-pandemic peak, as shown below.
Payrolls > prior peak
Source: Charles Schwab, Bloomberg, Bureau of Labor Statistics (BLS), as of 7/31/2022.
In addition, average hourly earnings were also higher than expected at 0.5% month/month and 5.2% year/year. A still-hot labor market alongside strong wage growth (albeit negative when adjusting for inflation) suggests inflation won't come fully off the boil until sufficient labor market slack is seen for a sustained period. In keeping with those thoughts, expectations for a 75-basis-point hike at the September Federal Open Market Committee (FOMC) meeting jumped immediately after the jobs report was released. In addition, the notion of a coming "Fed pivot," which contributed to the recent market rally, likely needs to be dismissed—at least for now.
Bond yields across the curve spiked (especially two-year and three-year yields), leading to a further inversion of the curve (only the 10-year-three-month spread remains positive). The descent of 100 basis points in the 10-year yield—from its near 3.5% peak in mid-June to its recent low of 2.5% as August began—was also a key contributor to the strength in the equity market (the S&P 500's recent trough was in mid-June). A more aggressive Fed, alongside yields rising swiftly, again helps to explain the initial swoon in stocks that followed the release of the jobs report.
Household survey a tell looking ahead?
The household survey, from which the unemployment rate is calculated, was significantly more tepid with a gain of 179k (following a drop of 315k the prior month). The unemployment rate's drop of only one-tenth to 3.5% was partly explained by a disappointing drop in the labor force participation rate (LFPR). For what it's worth, at economic turning points, the household survey has been a better indicator of labor market health than the payroll survey. As shown below, using a six-month rolling average to highlight the trend, the household survey is telling a less-robust labor market story.
A tale of two surveys
Source: Charles Schwab, Bloomberg, Bureau of Labor Statistics, as of 7/31/2022. Y-axis is truncated for visual purposes.
As mentioned (and shown below), there was a drop in the LFPR; at 62.1%, it is at its lowest level since last December. However, better news came via its prime age (25-54) category, which did tick higher. As an aside, I suppose I'm well past my prime since my 58th birthday is approaching quickly, while Kevin is at the start of his prime!
Source: Charles Schwab, Bloomberg, Bureau of Labor Statistics, as of 7/31/2022.
What say the leading indicators?
Part of the reason for the miss on the part of economists (economic data doesn't "miss" … economists miss the mark with their estimates) is that a broad swath of leading labor market data has been signaling a faltering labor market. In particular, initial unemployment claims (a key leading economic indicator) are up about 50% from their March low—well above the average lead-in to recessions historically, as shown below.
Source: Charles Schwab, Bloomberg, Department of Labor, as of 7/29/2022. Y-axis truncated for visual purposes.
As noted, claims are a component of The Conference Board's Leading Economic Index (LEI), which has rolled over this year. As shown below, this should begin to show up in weakness in payrolls (but of course that could have been said five minutes before Friday's data release).
LEI's rollover a warning?
Source: Charles Schwab, Bloomberg, Bureau of Labor Statistics, The Conference Board. Leading Economic Index (LEI) as of 6/30/2022. Nonfarm payrolls as of 7/31/2022.
Job openings have rolled over, too, as shown via the Job Openings and Labor Turnover Survey (JOLTS) data below. Openings continue to outpace the number of people unemployed—even accounting for the fact that openings are likely overstated based on how they're calculated, and lag other labor market data by at least a full month.
Openings rolling over
Source: Charles Schwab, Bloomberg, Bureau of Labor Statistics. Unemployed as of 7/31/2022. JOLTS as of 6/30/2022.
Also fooling economists, layoff announcements are up meaningfully from their 2021 lows. As shown below, three out of the past four months have seen year-over-year increases in job-cut announcements, while the anecdotal data continues to bode fairly ill (notably within the technology sector).
Job-cut announcements turn "positive"
Source: Charles Schwab, Bloomberg, as of 7/31/2022.
As shown in the Institute for Supply Management (ISM) charts in another section below, although both services and manufacturing headline indexes remain in expansion territory (>50), their employment components are decidedly weaker. Another rub is that strong job growth coupled with weak gross domestic product (GDP) growth (or no growth in the case of the first and second quarter this year) is a sign of weak/weakening productivity, which in turn bodes ill for corporate profits and margins.
A less-sweltering inflation forecast?
As noted, the Fed's other mandate (inflation) is facing a similar backdrop as the labor market—with the difference of course being that we would welcome a significant drop in inflation but not a spike in job losses. While coincident indicators—such as the Consumer Price Index (CPI)—indicate price growth is still running hot, leading indicators are telling (or attempting to tell) a different story. It remains encouraging that gasoline, energy-related commodity, and shipping prices have rolled over, but the unfortunate reality is that consumers are reeling from a 40-year high in inflation that is increasingly being driven by stickier services components.
Shown in the chart below, CPI (as of June) increased at a 9.1% annual rate. As the pace picked up throughout the pandemic, core services (which excludes energy) has become the chief driver, contributing 3.2 percentage points to headline inflation. That's an (unfortunately) impressive feat when considering that Energy contributed 3 percentage points to CPI’s 9.1% gain in June—a month in which oil prices were hovering firmly above $100/barrel.
Unwelcome services force
Source: Charles Schwab, Bloomberg, Bureau of Labor Statistics, as of 6/30/2022. Core excludes food and energy.
As mentioned, commodity prices have experienced a significant decline over the past couple months. Perhaps unsurprisingly, the recent peak in gasoline prices occurred in mid-June (oil prices have also slid considerably in that timeframe), alongside the aforementioned peak in the 10-year yield and the most recent trough for the S&P 500. Price action has started to cement expectations that the peak in headline inflation may be behind us.
While it's never possible to predict where prices will go—especially in this environment—there is building and perhaps sufficient evidence that the worst of the pandemic- and war-driven inflationary pressure is in the rearview mirror. As shown below, the shipping rate for a 40-foot freight container from Shanghai to Los Angeles has plunged by nearly 40% from a year earlier. That is the lowest year-over-year change since the pandemic erupted and well off the high of more than 240% last year. Notably, the price level isn't back to its pre-pandemic low, but it's the rate of change that matters more.
Pay (less) extra for shipping
Source: Charles Schwab, Bloomberg, as of 8/4/2022. The World Container Index (WCI) assessed by Drewry reports actual spot container freight rates for major East West trade routes.
Additionally, the prices paid and supplier deliveries components of both ISM surveys—as shown below—have come off the boil. The upside is that this bodes well for the pass-through (or lack thereof) of higher costs to consumers; but, as mentioned earlier, the employment components of both manufacturing and services are not signaling future strength on the labor front.
Weak prices, weaker labor
Source: Charles Schwab, Bloomberg, as of 7/31/2022.
Source: Charles Schwab, Bloomberg, as of 7/31/2022.
Supply-demand tug of war
Even though headwinds for headline inflation are building, the metric that the Fed pays most attention to is the Core Price Consumption Expenditures (PCE) inflation index. The current 4.8% year-over-year increase is fortunately down from the February peak of 5.3%, but it's uncomfortably above the 1.9% rate at the start of the pandemic and the Fed's flexible target of 2%. The persistent difficulty throughout the pandemic for the Fed has been navigating an inflation environment that is increasingly driven by supply-side factors.
To be sure, demand-driven components have borne responsibility as monetary and fiscal policy were incredibly accommodative at the start of the pandemic; but ripple effects from the pandemic and war in Europe have exacerbated price pressures to the upside throughout the world. As such, demand- and supply-driven contributions to core PCE have been nearly equal, as shown in the chart below.
Meet in the middle
Source: Charles Schwab, Federal Reserve Bank of San Francisco (Supply- and Demand-Driven PCE Inflation – Economic Research (frbsf.org)), as of 6/30/2022. Figure divides year-over-year changes in core PCE inflation (using authors' calculations) into contributions that can be determined as driven by supply and demand, with remainder marked as ambiguous. Demand-driven categories are identified as those where an unexpected change in price moves in the same direction as the change in quantity in a given month. Supply-driven categories are identified as those where unexpected changes in price and quantity move in opposite directions.
While the Fed has openly admitted to its inability to rein in supply-driven inflation, it has acted swiftly and aggressively to tamp down demand, evidenced by the several-hundred basis points' worth of policy rate increases this year (and the prospect of further tightening). The light at the end of the inflation tunnel may be visible, but the key moving forward is less about the timing of the peak, and more about the level at which inflation ultimately settles. If it stays elevated and takes longer to cool—which will grow more likely if core services (the stickier component) climbs higher—that will help push the Fed to keep its foot on the brakes.
One of the silver linings for now is that inflation expectations have rolled over, dispelling the notion that individuals expect higher prices to persist for several years to come. As shown below, two- and 10-year inflation breakeven rates are off their peaks of 4.9% and 3%, respectively. Put simply, the market doesn't expect today's sky-high inflation to last long into the future. That gives the Fed some cover, but it's hardly enough (as several members have reminded us) to halt rate hikes in the near term.
Inflation expectations subdued
Source: Charles Schwab, Bloomberg, as of 8/5/2022.
While the hot July jobs report has likely given the Fed sufficient reason to maintain a hawkish stance in the near term, it is worth noting that two CPI prints and another jobs report stand between now and the next rate decision (barring any inter-meeting surprises). As such, July's strong wage growth and further evidence of labor market tightness might prove to be stale if inflation starts to ease and payrolls in August (a month that is notorious for large subsequent revisions) show some weakness.
Even if inflation looks to be peaking and rolling over, the Fed has made it clear that price pressures today remain uncomfortably high. Not only does that keep a 75-basis-point rate hike on the table for September, it increases the potential duration of the rate hiking cycle in the future. Assessing each inflation and jobs report has gotten increasingly difficult given the Fed's relatively new practice of making meeting-by-meeting decisions on policy. However, that reinforces the fact that investors should focus more on the big picture for policy. Macro forces are still unsupportive of stronger economic growth or equity performance, thus keeping pressure on further gains and elevating the probability of a recession.