Week in Review. Why the Fed should like the jobs report

Some welcome news on the inflation front

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The first week of 2023 is in the books, and stocks caught a bid on Friday after the jobs report. Fed Chairman Jerome Powell has been making hawkish comments ever since the December FOMC meeting, which has weighed on stocks. The FOMC minutes were disappointing, so the data helped improve the overall mood.

The FOMC minutes were released on Wednesday, and investors were eager to see what everyone was missing. At the December Fed meeting, the central bank hiked interest rates, as expected. The surprise was the forecast for the future Fed Funds rate. In September, the Fed saw the end-of-2023 Fed Funds rate in a range of 4.4% - 4.9%. Investors were hoping that the two positive surprises on the Consumer Price Index would cause the Fed to signal it was ready to wrap up its rates hikes. That didn’t happen - in fact they upped their forecast to a range of 5.1% - 5.4%. Stocks and bonds kind of limped into the end of 2022 after that. The FOMC minutes shed some light on the Fed’s thinking.

The FOMC minutes did mention the November and December CPI prints, however they said that they needed to see more evidence that inflation was slowing. To understand this comment, you have to understand how the Fed is viewing the inflation issue.

Jerome Powell has discussed his view of inflation as almost a three-legged stool. The three components are goods inflation, housing, and services ex-housing. If you have gone to the gas station recently, you know that gasoline prices are retreating, and even some food prices aside from eggs are declining. Industrial materials are also falling as demand declines. The jump in goods inflation over the past two years was due primarily to supply chain issues related to the COVID-19 pandemic. These issues have largely been addressed. Goods inflation is more or less finished as a driver of inflation.

The second leg is housing. Home prices went on a tear during the pandemic, driven by low rates and an exodus of wealthy urban dwellers who wanted to escape expensive urban areas, especially in California and New York. Californians bought property in places like Boise, Las Vegas and Phoenix, while New Yorkers fled to Florida and Nashville. Some of these MSAs saw gargantuan appreciation, on the order of 30% - 40% per year. Over the summer, higher rates caught up with a lot of these markets, and prices began flatlining. Now that the gold rush is over, a lot of these real estate markets are going to revert back to what the local economy can bear. Bad news for Tanner the Tech Bro who bought a place in Boise. The bottom line is that home price appreciation is returning to normal, and is negative in many expensive California markets . As prices flow through to rents, the housing component of inflation will probably disappear sometime next summer.

The final leg is core services ex-housing, and this means one thing: wages. This is what the Fed is worried about. The Fed is trying to avoid the situation we had in the 1970s - the wage / price spiral. During the 1970s, inflationary expectations began to get built into wage negotiations, particularly in collective bargaining agreements. These raises created more demand for goods, which in turn raised prices. These new increases were then taken into account into future wage negotiations. The wage / price spiral became a self-reinforcing phenomenon and it took an extremely deep and painful recession to bring it to a halt. The recessions of 1980-1982 were the deepest since the Great Depression at that time. This is what the Fed is trying to avoid. They did mention the wage price spiral explicitly in the minutes:

“Participants noted that, in the latest inflation data, the pace of increase for prices of core services excluding shelter—which represents the largest component of core PCE price inflation—was high. They also remarked that this component of inflation has tended to be closely linked to nominal wage growth and therefore would likely remain persistently elevated if the labor market remained very tight. Consequently, while there were few signs of adverse wage-price dynamics at present, they assessed that bringing down this component of inflation to mandate-consistent levels would require some softening in the growth of labor demand to bring the labor market back into better balance.”

It is all about wage growth.

Interestingly, a lot of what caused inflation in the 1970s had little to do with wages. Sure, wages mattered. But so did the Arab Oil Embargo, Nixon shutting the Gold Window, Vietnam + The Great Society and capacity constraints on aging manufacturing plants built at the turn of the century.

Fast forward to today, the situations have some similarities. The massive government spending during COVID resembles the Keynesian pump priming of the Vietnam war and the Great Society. The supply chain issues of today are similar to the capacity constraints of yesteryear. Today’s unemployment rate and initial jobless claims are almost identical to the late 60s / early 70s. There are differences too - especially quantitative easing and globalization. That said, what can the Fed control? Not fiscal policy. Not supply chain issues. It can only affect the labor market, and only indirectly.

The Fed wants to see the labor supply and demand in better balance. To do that it will raise rates to discourage business investment and hiring. It needs wage growth to fall in order to pull inflation back down to its 2% target. This will get harder politically as the unemployment rate rises and the economy slows, so it is striking while the iron is hot. Bringing wage growth below inflation means falling wages on an inflation-adjusted basis which will surely ignite pushback in Washington. Which brings us to the jobs report.

The jobs report was more or less a goldilocks report if you look at the reaction in the stock and bond markets. Stocks loved it; the S&P 500 rose 2.25% and the NASDAQ rose 2.5%. The reaction in the 10 year bond was even more dramatic. The yield dropped from 2.73% pre-report to 2.56%, the lowest level in 3 weeks.

Nonfarm payrolls increased by 223,000 and the unemployment rate fell to 3.5%. Average hourly earnings rose 0.3% month-over-month and 4.6% year-over-year to $32.82. This was below the Street consensus of 0.4% month-over-month and 5.0% year-over-year. That was what triggered the big rally in stocks and bonds.