The Fed’s Continued Hawkish Tone Disappoints Wall Street

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

Investors sold off equities last week as employment data and a backward-fixated Federal Reserve dashed hopes that the pace and size of rate hikes are set to ease in the near future.

The relatively strong employment reports out last week would be easy to chalk up as a reflection of where the economy has been — as opposed to where it is headed — if it weren’t for Federal Reserve Chairman Jerome Powell’s comments on Wednesday in announcing the latest 75-basis-point rate hike. During his press conference, Powell made it clear that the Federal Open Markets Committee wants to see cracks in lagging data before it considers reducing the size of rate hikes or potentially pausing the current tightening cycle.

Ironically, Chair Powell was emphatic that the Fed would need to see a string of improved inflationary readings and sustained softening in the employment picture while also acknowledging that forward-looking data suggests the elements that created the surge in inflation — overheated demand, low inventories and supply chain bottlenecks — have significantly improved or returned to pre-pandemic levels all together.

In explaining the Fed’s thinking, Powell noted the board believed undoing economic damage caused by being too aggressive in raising rates would be easier than trying to control inflation should rate hikes cease before price pressures are fully reined in.

However, a closer look at the employment data — an area of particular focus for the Fed — suggests that the board’s concerns are likely overblown. While Friday’s jobs report showed that employment increased by 261,000 positions in October, on top of September’s 315,000 new jobs, the unemployment rate ticked up to 3.7 percent from the prior month’s reading of 3.5 percent. The seemingly contradictory data is the result of the two statistics being derived from two different surveys from the Bureau of Labor Statistics. The so-called Nonfarm Payrolls report is used to measure jobs added in a month, while the Household report is used to calculate the unemployment rate. The two measures occasionally diverge for short periods of time, as was the case in October, when the Household report showed 328,000 workers lost their jobs. While the gaps between the two generally close over longer periods, the divergence between the two this year has reached historic levels. Since April of this year, the Nonfarm Payrolls measure has pointed to 2.45 million new hires, while the Household report registered a gain of just 150,000 jobs for the entire period. With the exception of the early months of COVID, the April-to-October difference between the reports is the greatest since the late 1950s.

April is an important starting date because the labor differential from the Conference Board peaked in March 2022 and has been on a downward trajectory since. The differential is a measure of the gap between the number of respondents who believe jobs are easy to land and those who report challenges finding work. Since the March reading, the measure has fallen nearly 15 percentage points, including 5.6 points in October. The latest reading now stands at 32.5, which is well below the March high of 47.1 percent. Historically, each time the measure has declined to the degree that it has this year, the economy had already started to see job losses, and unemployment rates had moved higher.

A similar picture can be found in other data. Reports from the Institute of Supply Management show companies in both the services and manufacturing sides of the economy had robust hiring plans early in the year, but those intentions cooled in April, with the employment index for manufacturers falling to 50.5, while the reading for services was 49.5 (readings below 50 indicate contractionary activity). Since then, hiring intentions for both sides of the economy have remained weak, with services registering six of the past seven readings at 50.2 or lower, while the manufacturing index logged five of its past six readings below 50.

To be sure, pockets of the economy continue to face a tight employment market. The health care and hospitality industries continue to see labor constraints, but that is a function of evolving demand as industries that were most hurt by COVID lockdowns continue to regain lost footing.

The easing demand for employees can also be seen in payroll data, which shows wages for all employees were up 4.7 percent year over year in October, down from 5.8 percent year over year in March. When looking solely at production and non-supervisory employees, the easing is more striking, going from 6.7 percent year-over-year growth in March to 5.5 percent in the most recent data.

Put simply, employment is following a similar pattern to what we’ve seen in manufacturing and housing and are beginning to see in the services sector — a slow turn downward that is likely to accelerate in the coming months.

While Chair Powell’s comments last week suggest that the Fed’s fear of a return to embedded inflation of the 1970s is so great that it is willing to overlook improving trends in its battle against price pressures, the Board did leave itself some wiggle room. In a released statement announcing the latest hike, the board noted, “In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” This suggests that board members realize that effects caused by the significant rate hikes this year could be gaining momentum and may become too significant to ignore in the coming months.

Wall Street wrap  

While we will have to wait until later this week to see if the latest data is making an impact on inflation readings, the data released last week continue to show demand is weakening, and price pressures are easing for businesses.

ISM numbers point to further relief on inflationary pressures: The latest manufacturer data from the Institute for Supply Management (ISM) show the manufacturing sector continues to soften, while supply chains have fully healed. But more importantly, inflationary pressures for manufacturers have subsided.

The composite reading for the manufacturing index came in at 50.2, down from September’s level of 50.9 and the lowest reading since May of 2020. The slowdown in activity over the past several months has allowed supply chains to heal as reflected by the latest reading of 46.5 (lower numbers indicate faster deliveries). For context, this measure was as high as 78.8 in May 2021 and 67 in April of this year.

Prices paid by manufacturers also continued to drop, with the latest reading coming in at 46.5. Contrast that to the 92.1 reading in June of last year and the March 2022 level of 87.10. The latest figure translates to a drop of 40.5 percentage points in just seven months, with 31.9 percentage points of the decline coming since June. As the dramatic easing in price pressures continues to work its way through the manufacturing process, we believe consumers will begin to feel the improvements.

The improvements in delivery times and input costs come at a time when future demand is faltering. The new orders reading for October came in at 49.2, up from last month’s 47.1 but still in contractionary territory. The latest orders number marks the fourth time in five months that demand has dipped below 50. The upshot of weak demand is that pricing power for manufacturers has been significantly curbed.

The services side of the economy is proving more resilient; however, it too is well off the highs seen in May 2022. Price pressures for service providers remained elevated at 70.7, but the reading shows continued progress as October’s level marked the fourth consecutive reading near or below 70 percent. For context, the nine readings prior to July were all above 80 percent. Supplier deliveries ticked up to 56.2 compared to 53.9 in September but remain manageable for service providers.

Perhaps of greatest interest in the services report were comments from Anthony Nieves, chair of the ISM Services Business Survey Committee: “Supplier deliveries continued to slow at a faster rate in October. Based on comments from Business Survey Committee respondents, growth rates and business levels have cooled. There are still challenges in hiring qualified workers, and due to uncertainty regarding economic conditions, some companies are holding off on backfilling open positions. Supply chain and logistical issues persist but are not as encumbering as they were earlier in the year.”

In essence, we believe the services side of the economy is approaching an inflection point, much as manufacturing did earlier this year. As price pressure for this side of the economy soften further and manufacturing remains subdued, lower rates of inflation will begin to permeate the economy on a broad scale.

The week ahead

Monday: The Federal Reserve will release its latest look at the financial condition of consumers through its Consumer Credit report. Consumers’ balance sheets have been an area of strength, and we will be looking to see if inflation has eroded any of that strength.

Tuesday: The National Federation of Independent Business Small 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 as well as signs on the direction of prices at both the consumer and wholesale levels. We will be watching for evidence that a slowing economy is influencing hiring and business investment decisions of small companies.

Thursday: The big report for the day will be the Consumer Price Index report from the Bureau of Labor Statistics, as the markets will be scrutinizing the report for signs that prices continue to cool. This backward-looking inflation measure has been slow to reflect easing of housing costs, and we will be watching for indications that the easing in rent pressures (which peaked in February) are beginning to make an impact on this measure.

Friday: The University of Michigan will release its preliminary report on October consumer sentiment as well as inflation expectations. After a brief uptick this summer, consumer expectations for inflation in the intermediate term have largely remained anchored. Federal Reserve Chairman Jerome Powell again noted in his press conference following last week’s rate hike that well-anchored expectations are needed to prevent high inflation from becoming embedded in the economy.  We will be watching the report for signs that respondents continue to believe inflation will return to historical norms in the years ahead.

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