Ajay Rajadhyaksha is global chair of research at Barclays.
Financial markets trade on narratives. And for the past several weeks, the dominant story in both bond and equity markets has been that the Fed will pivot, and soon. Investors expect a rapidly weakening economy to force the US central bank to do an about-turn, and cut rates barely months after hikes finish.
This belief built up a head of steam across July, with many investors suggesting that the Fed could signal a shift at its Jackson Hole retreat in late August. Every weak housing data point fed into this narrative; every contraction in PMI was grist for this mill. A sharp pullback in commodities prices, a collapse in business and consumer confidence, a decline in market expectations for inflation over the next decade – all these pointed in that same direction. And then there was history: the Fed did a volte-face in both of the last two hiking cycles. Hikes in the summer of 2007 gave way to cuts in 2008. And memorably, the Fed hiked in December 2018 only to change course by January 2019. Small wonder that markets have been waiting for the US central bank to signal a shift again.
Easier said than done.
The data that matter most – inflation and wages – are still too strong for the US central bank to breathe easy. Way too strong. And the numbers are accelerating, even before July’s strong jobs report. Consider the last inflation print. Core CPI (which excludes food and energy prices) over 6 months is running at an annualised pace of almost 7 per cent. But the 3-month rate is almost 8 per cent. And the 1-month number annualised is nearly 9 per cent. That means core CPI is speeding up, not slowing down, and is in a very different zip code than the Fed’s 2-per-cent target.
Even more important is the move in wages. For the past few months, it looked like wage growth was slowing down. Average hourly earnings, reported in the monthly jobs report, seemed to have settled into a 3.5- to 4-per-cent annual rate. Then three things happened all at once. First, the Atlanta Fed wage growth tracker showed that wages accelerated strongly in June (6.7 per cent annually):
Second, the average hourly earnings data were revised upwards. Lo and behold, wages are no longer slowing in that series.
But most significant was the latest release of the Employment Cost Index (ECI), the Fed’s preferred indicator. Private sector wages accelerated sharply to a 6.5-per-cent annualised pace in June. The cherry on the cake, of course, was the unemployment rate reaching a post-Covid low last week. The US labour market is not just not slowing down. It is speeding up.
It is true that labour markets are famously backward looking. In September 2008, around the financial crisis, the jobless rate was still 6.1 per cent. When it peaked at 9.9 per cent a year and a half later, the US was well on its way to recovery. Even so, Fed officials care deeply about wages. If high wage expectations get embedded in an economy, high inflation can remain ‘sticky’ for far longer. A 2-per-cent inflation target is hard to achieve if per-capita wages rise 6 per cent in 2023. Central bankers don’t like admitting it, but a primary goal of rate hikes is to cause enough job losses to ensure that wage growth slows down. And if that isn’t happening despite several rate increases, it adds pressure on the central bank to raise rates further, and keep them high for longer.
Admittedly, monetary policy does work with a long and variable lag. That is why central bank decisions are usually based on forecasts; today’s data is not supposed to be the dominant driver of today’s policy. But these are not normal times. The inflation spike of the last 12-15 months has been massive, persistent, and made a mockery of forecasts. And one by one, central banks have had to adjust policy to incoming inflation data. The Fed broke its own forward guidance and hiked 75bp in June because of a strong May CPI report. And the ECB followed in July, hiking 50bp despite promising 25bp.
Strong jobs reports are usually greeted with enthusiasm in the Marriner S Eccles building. But the starting point on inflation, including core inflation, is simply too high. Markets have gotten ahead of themselves in expecting the Fed to start taking a more dovish approach. As things currently stand, any Fed surprises over the next few months are more likely to be hawkish. Investors waiting for an imminent pivot will have to keep waiting.