My Fed Fight Goes On – I Still Expect an 8% FFR in 2023

Summary

• Minutes from the December meeting reveal the Fed is concerned about the upside risk to growth and not planning to cut interest rates in 2023.
• Friday’s nonfarm payrolls data revealed a deeply overheated labour market, with slower-than-expected wage growth likely to be transitory.
• Q4 GDP data is due on 26 January, where I expect 3% against consensus of 1.1% QoQ SAAR.

Market Implications

• Markets underestimate upside growth, inflation risks and Fed tightening. In particular, a distortion in wage growth data has them overly optimistic about a soft landing.
• I still expect a 50bp hike of the federal funds rate (FFR) at the February FOMC.
• I expect growth to accelerate, the Fed to react with faster rate hikes and a recession, but not before end-2023.

Cuts in 2023?

New year, new narrative? It seems so for markets, anyway. They believe the inflation dragon is pretty much slain, the economy cooled through December, and the Fed can – finally – start slashing rates in 2023. They currently price about 40bps of cuts! Reflecting that rosy outlook, stocks and bonds rose last week, the curve steepened, and the dollar weakened.

But I disagree – I remain out of consensus in expecting a 50bp hike at the February meeting, a terminal rate near 8% and a growth acceleration followed by recession in late 2023. Below, I explain why.

Is Policy Biting?

Minutes from the Fed’s December meeting came out on Wednesday, followed by nonfarm payrolls on Friday. And this week, CPI data will take centre stage with Q4 GDP data due on 26 January.

The minutes revealed a Fed concerned about a possible rebound in growth and the poor transmission of its policy tightening to financial conditions. On growth, the Fed noted:

• ‘Real GDP appeared to have rebounded moderately in the second half of 2022.’
• ‘Participants noted that growth in consumer spending in September and October had been stronger than they had previously expected.’
• ‘With regard to the business sector, views on investment prospects varied across businesses and Districts.’

Meanwhile, concerns mounted over easing financial conditions and the weak transmission of monetary policy to the economy. That is, they were not seeing policy bite (Chart 1).

That concern translated into a firm statement from the Fed: ‘No participants anticipated that it would be appropriate to begin reducing the federal funds rate target in 2023.’ Minneapolis Fed President Kashkari (hawk, voter) recently called for a further increase in the terminal FFR to 5.4% compared with the December SEP’s 5.1%. I expect more of these to come.

The Labour Market Remains Tight

Complicating the Fed’s efforts is a labour market that remains extremely tight. December nonfarm payrolls (NFPs) roughly aligned with expectations. At 223,000, they were higher by 20,000 than the 203,000 expected. But the two-month net payroll revision was ‑28,000.    

The gap between household and payroll employment narrowed, with household survey employment increasing by 717,000. With such a large increase, the unemployment rate fell 20bp to 3.5% despite a 20bp increase in participation.

The big picture Friday’s data painted remains of an extremely overheated labour market that is only slowly rebalancing. The gradual narrowing of the gap between labour demand and supply growth demonstrates this (Chart 2).

The real surprise in Friday’s data was slower wage growth. Average hourly earnings (AHE) was 0.3%, 10bp below expectations, and November was revised down to 40bp from initially 60bp. But how is that possible with such a tight labour market?

Firms reacted to the pandemic by firing heavily (unlike in normal recessions when firms typically hoard workers). Then when the recovery came, they were understaffed, could not attract new workers, and instead had to increase hours worked (and hence overtime). That overtime is paid at time and a half, distorting wage growth figures such as AHE.

Now, companies are getting workers back, hours worked (and hence overtime) is falling, lowing average wage. But if you look at median wages, you see the real picture (Chart 3).

This distortion is normalizing, but it will take a quarter or two. Meanwhile, it could be wrong-footing the market, which continues to ignore the Fed. This could see a return of a goldilocks market regime, positive for stocks and bonds, that could well extend into Q2 ­ but not forever.

Q4 GDP Growth to Remain Around 3%

The consensus projects Q4 growth at 1.1 QoQ SAAR, down from 3.2% QoQ SAAR in Q3. In my view, Q4 growth is more likely to be near 3%. Here are three data-driven reasons:

• Hard data shows growth strength. My preferred aggregator of hard data is the Atlanta Fed GDP nowcast, currently at almost 4%. This forecast is likely one of the inputs that led the US Federal Reserve (Fed) to become concerned by upside risks to growth at the December FOMC meeting.

• Okun’s Law suggests Q1-2 growth are outliers. The relationship between unemployment and growth, Okun’s law, has been very stable in the US with about a 2ppt increase in growth linked to a 1ppt decrease in unemployment (Chart 5). From this perspective, Q1 and Q2 GDP growth of -1.6% and -0.6% are outliers. By contrast, Q3 growth of 3.2% aligns with Okun’s law. The continued very low unemployment in Q4 suggests growth is in a similar range to Q3.

• Real household income is troughing. Household real income, excluding government transfers, reveals the stability of economic momentum without government support. Turning points also often lead economic recessions and expansions – in this case an expansion given labour market strength.

We can combine these data-driven reasons with clear macro signals. These are the end of fiscal consolidation, still loose monetary policy, and a weaker dollar and improving trade deficit (Chart 4).

What to Expect Going Forward

Given the above reasons, my calculations lead me to expect Q4 GDP to positively surprise markets by coming in at around 3% QoQ SAAR. Markets, however, will probably ignore its consequences for inflation. This would be because of perceptions that inflation is trending downwards.

The Fed, however, are unlikely to ignore it. So while we might enter a brief period of positive sentiment for stocks and bond, I expect this to end as the Fed keeps up the pressure. I see a 50bp hike at the February meeting, a terminal rate near 8% and a recession around end-2023.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed, the IMF, and the World Bank. She joined Macro Hive soon after its inception.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)