Are Investors Underestimating the Fed’s Resolve?

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

Investors continue to believe that the Federal Reserve is likely done raising rates and that the economy is on its way to a soft landing. The thinking goes that with the tightening cycle potentially ending, the economy could slow just enough for the supply and demand of workers to come into balance but not so much that consumer demand stalls and leads to a surge in layoffs and a resulting recession. Equities have now notched a second straight week of gains as bond yields remained well below their recent highs.

While we appreciate the appeal of such a narrative, we believe it underestimates how seriously the Fed views the current labor market tightness as a threat to its goal of returning inflation to its long-term target of 2 percent. Fed Chairman Jerome Powell reiterated the point last week as he spoke at the International Monetary Fund research conference. Many of his comments echoed remarks he made following the decision of the Federal Open Markets Committee to leave rates unchanged earlier this month. However, at his latest appearance he put a greater emphasis on the Fed’s resolve to bring the inflation rate sustainably down to its target of 2 percent, noting that members of the Fed were “not confident” that Fed policy was restrictive enough to achieve its goal and emphasizing the Fed “will keep at it until the job is done.” And while he acknowledged that significant progress had been made in reining in price pressures, thanks to the unwinding of COVID-induced supply and demand anomalies, he noted the Fed is “attentive to the risk that stronger growth could undermine further progress in restoring balance to the labor market and in bringing inflation down, which could warrant a response from monetary policy.” And while he acknowledged that the Fed wants to avoid causing a recession, he emphasized it is prioritizing the risk of ongoing elevated inflation over the potential for rising layoffs and a resulting recession. “We don’t want to go too far, but at the same time, we know that the biggest mistake we could make would be, really, to fail to get inflation under control,” Powell said.

Put simply, we believe the Fed continues to view wage pressures as an obstacle to ongoing progress in the disinflationary process and sees a slowdown in demand as the most likely path to creating slack in the employment picture. Given the Fed’s concerns about wages we believe it will be unwilling to ease current restrictive rate levels until there is sustained evidence that the labor market has sufficient slack and inflation has returned sustainably to or near 2 percent. Unfortunately, given that employment is a lagging indicator of the economy, we believe that by the time labor demand has eased to the point that annual wage gains have fallen to 3.5 percent or less on a consistent basis, a potential economic slowdown will have already arrived and may get worse as the job market cools.

Indeed, the latest consumer sentiment survey released by the University of Michigan shows that the impact of higher rates is already starting to wear on consumers’ views. Perceptions of buying conditions for everything from houses to cars and durable goods have also deteriorated due to high interest rates. For example, views of home-buying conditions plummeted 25 percent in November and are now tied with an all-time low for the measure reached in 2022. Similarly, perceived conditions for buying durable goods fell 16 percent for the month, and sentiment about the market for vehicle purchases reached lows not seen since December of last year.

Preliminary readings of consumer sentiment came in at 60.4 in November, down from 63.8 in October and marking the fourth consecutive month of declining readings. Notably, sentiment about current economic conditions dropped 4.9 points to 65.7 from the previous reading of 70.6, and long-run economic outlook dropped precipitously. “While current and expected personal finances both improved modestly this month, the long-run economic outlook slid 12 percent, in part due to growing concerns about the negative effects of high interest rates,” said Surveys of Consumers Director Joanne Hsu in a statement accompanying survey results.

It’s noteworthy that interest rate levels are weighing on consumers. As we’ve noted in recent commentaries, consumers and business alike had been insulated from the impact of higher rates as they continued to service loans made at the previous lower rates. We view this report as evidence that the higher rates are starting to filter through the economy more broadly and are making an impact on consumers. As time goes on, debt servicing costs will continue to climb throughout the economy as more loans are repriced at the current higher rates. Chairman Powell reiterated this point as well in his comments last week.

The drop in sentiment comes as inflation expectations have begun to creep higher. The latest survey shows that respondents expect inflation to run at a rate of 4.4 percent in the coming year, up from October’s reading of 4.2 percent and well above September’s level of 3.2 percent. Similarly, long-term expectations now peg inflation growing at a rate of 3.2 percent, up from October’s reading of 3.0 percent and marking the highest level recorded since 2011. It’s important to recall that the Fed has long monitored inflation expectations because it believes that if consumers’ view of elevated inflation has become embedded in the economy, they may attempt to purchase goods and services in advance of the next price hike and thereby create a surge in demand that will reinforce an inflationary loop.

With inflation expectations moving higher, we believe the Fed will closely scrutinize next week’s Consumer Price Index reading particularly in light of recent upticks in some of the other inflation readings, including various trimmed mean measures from individual Federal Reserve banks.

A word on the U.S. credit rating: On November 10, Moody’s, one of the three major commercial credit rating agencies in the U.S., downgraded its outlook for its rating for U.S. government credit to negative. We don’t see the decision by Moody’s as having a large and immediate impact on the view the global investment markets hold for U.S. Treasurys. However, it’s important to remember that the country’s annual interest costs on servicing its debt are rising. With interest payments taking up more resources in the budget, it is likely borrowing costs will become an issue that restricts future government spending. This could mean that we may see an erosion of the ultra-favorable backdrop for risk-taking that has existed over much of the prior decade. While the erosion of U.S. Treasury credit ratings rightfully causes investor worries, we note that Treasurys now offer real yields above 2 percent, a level we feel compensates investors for both credit and inflation risks.

Wall Street wrap

Despite a week of light data, the picture painted by economic reports out last week suggests the drawdown of liquidity in the economy continues, while the job market shows signs of slowing.

More tightening by lenders: Businesses and consumers saw continued tightening of lending standards during the third quarter, according to the results of the Federal Reserve’s Senior Loan Officer Opinion Survey on Lending Practices. The net percentage of lenders reporting tighter lending standards for commercial and industrial loans for large and middle-market firms came in at 33.9 percent. Lenders who noted an increased willingness to issue consumer installment loans remained tight at –20.4 percent—similar to the prior quarter’s reading of –21.8 percent. This is further evidence that the liquidity that helped fuel economic growth over the past few years continues to dry up because of the Fed’s aggressive rate hike campaign. The level of tightening loan availability as well as the decline in demand are consistent with levels during previous recessions and continue to influence our outlook.

Job market leading indicator points down: The latest release of the Conference Board Employment Trends index suggests that the labor market is weakening. The index is an aggregate of eight labor market indicators and is a forward-looking measure. When numbers in the index increase, employment is likely to move higher; conversely, a declining reading suggests that employment is likely to fall. The latest release out last week shows that the index declined to 114.16 in October from 114.63 the prior month. October’s reading continued a trend of declining readings that began after the measure peaked at 119.55 in March 2022, and the measure is now down 3.2 percent on a year-over-year basis. At the seven other times the index has seen year-over-year declines equal to or greater than the current 12-month drop, the economy has been in or fallen into recession.

Continuing jobless claims increase: Weekly jobless claims numbered 217,000, down 3,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 212,250, an increase of 1,500 from the previous week’s revised average. Continuing claims (those people remaining on unemployment benefits) were at 1.834 million, an increase of 22,000 from the previous week and up from the recent low of 1.658 million in early September. As noted last week, while recent data shows that layoffs remain relatively low, the upward trend in continuing claims suggests displaced workers are finding it more difficult to find new jobs. Continuing claims are now 27.4 percent higher than year-ago levels; going back to late 1960, an increase of this magnitude has occurred on eight occasions and each time pointed to the economy either being in recession or on the verge of entering one.

The week ahead

Monday: We’ll get the release of the U.S. Treasury Federal Budget Debt Summary for October. In light of Moody’s decision to downgrade U.S. debt to a negative outlook due to large fiscal deficits and a decline in debt affordability, this is something we are monitoring.

Tuesday: The Consumer Price Index report from the Bureau of Labor Statistics (BLS) will be the big report for the week. Recent data has shown that progress in the disinflationary process has slowed; we will be dissecting the data to see if progress in bringing down the rate of inflation has stalled.

The National Federation of Independent Business mall Business Optimism Index readings for October will be out before the opening bell. The report should provide insights about the state of the labor market for small companies and expectations related to wages in the months ahead.

Wednesday: The latest readings from the BLS on its Producer Price Index will offer a front-line view of changes in costs for buyers of finished goods. It can provide insights into the direction of input costs faced by business and can indicate how prices may move at the consumer level in the future.

The U.S. Census Bureau will release the latest numbers on retail sales for October before the opening bell. The data should yield insights into whether consumers are adjusting their spending habits as a reflection of their expectations for inflation and the economy going forward.

The Empire State Manufacturing Index, released before the opening bell, will offer a look at the health of manufacturing and general business conditions in the influential New York state region.

Thursday: Initial and continuing jobless claims will be announced before the market opens. Initial filings were up again last week, as were continuing claims, and we will continue to monitor this report for sustained signs of changes in the strength of the employment picture.

We’ll get insights into the state of the new construction market mid-morning with the Home Builders Index from the National Association of Home Builders. Confidence among builders has waned as mortgage rates have climbed to nearly 8 percent. We’ll be watching to see if more builders have begun to offer concessions to attract buyers in this high mortgage rate environment.

We’ll get a look at the manufacturing side of the economy with the release of the latest industrial production figures from the Federal Reserve. Consumer spending has been a source of strength in the economy, while manufacturing has been weak. We’ll be watching to see if this report, along with the retail sales data released earlier in the week, shows a continued trend of industrial production remaining flat.

Friday: We will get October housing starts and building permits from the U.S. Census Bureau. This data, along with the Homebuilders Index released on Thursday, will provide insights on whether consumers can expect greater housing inventory in the months ahead.

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