Dueling Mandates

The Federal Reserve has two mandates: to help the U.S. economy maintain “price stability” and “maximum employment.” However, over the last 30 years, the maximum employment mandate carried the heaviest weight because inflation was largely a thing of the past. Since 1990, the Fed’s preferred measure of inflation (the personal consumption expenditure deflator) has averaged 2.1% - almost exactly in line with the Fed’s target of 2.0% inflation (see figure 1). Currently, that measure stands at 6.8% while the unemployment rate stands at just 3.5% (see figure 2). That makes the Fed’s decision easy – tighten policy to address price stability because the economy can tolerate some weakening in the labor market. That seems particularly true after July’s employment report showed the economy adding 528,000 jobs.

This line chart shows the Personal Consumption Expenditure Deflator, Year-on-Year Percent Change, from 1960 to 2020.

This line chart shows the U.S. Unemployment Rate in percent from 1960 to 2020.

Even prior to the employment report, Fed speakers were making the case for more rate hikes. San Francisco Fed President Mary Daly recent said saying the Fed is “nowhere near” finished fighting inflation, and Cleveland Fed President Loretta Mester said that she wants to see “very compelling evidence” that month-to-month price increases are moderating. Charles Evans said they are “at least a couple of reports away” from seeing the kind of inflation improvement Fed policymakers would want to demonstrate inflation is on the right track. Combined with the strong jobs report, a 75 basis-point rate hike has been put back on the table with the market now putting the odds of one at about 75%. The primary takeaway? The Fed is not done.

While more rate hikes are not what the market was hoping for, we find it encouraging that the labor market has held up thus far. After all, this is the most likely path to a soft landing (inflation decelerating, supply chain pressures ease, with demand cools, no major job losses). In theory, investors and the Fed should both be happy about the July jobs numbers, but it seems the strong labor market is increasingly being blamed for the stubborn inflation.

We find that interesting given that it was government stimulus and supply chain disruptions that caused this problem, not the labor market. In fact, the U.S. economy just recovered all the jobs lost due to the pandemic – some 29 months later. Rising wages might be seen as a concern with the latest print showing nominal average hourly earnings 5.2% higher year-on-year, but don’t forget that real wages have been falling steadily (see figure 3) and even nominal wages have come down from 5.6% in March 2022.

This line chart shows the Real Average Hourly Earnings, Year-on-Year Percent Change, from 1965 to 2015.

Yes, rising wages could make inflation stickier, but most of the inflation was in response to too much money chasing too few goods (the classic definition of what causes inflation). While transitory may have been the wrong word to use, inflationary pressures should improve gradually on their own given enough time. Just look at retailers that now need to cut prices because of too much inventory. Did the Fed have anything to do with that? It did not. Did the Fed cause the first wheat shipment to leave Ukraine’s ports recently? It did not.

It is understandable that the Fed feels obligated to respond to inflation because of its price stability mandate. In hindsight, the Fed probably should have started raising rates back to neutral in 2021. The potential problem we foresee in 2023 is higher policy uncertainty if unemployment starts to rise while inflation remains elevated. Will the Fed push forward with more rate hikes even if it means pushing the unemployment rate north of 5.0%? Or do they pause with hopes of avoiding significant job losses? We suspect it might be the former.

That said, the market appears to be expecting the latter as it is pricing in rate cuts in the back half of 2023 (see figure 4). While some investors see a Fed pause as reason to throw a “pivot party” and to take on more risk, we think a Fed cut would be a signal that it’s worried about a recession and that a soft landing may no longer be possible. Would it be a deep recession? Probably not, but recessions do tend to last about 11 months on average and the unemployment rate tends to rise by about 2.6%.

This bar graph shows the Implied Overnight Policy Rate in percent from August 8,2022 to January, 31 2024.

If the assumption is that the July employment report confirms the U.S. economy is not in a recession, then we must also assume that stocks may not have bottomed if a recession could still be ahead of us. Traditionally, the S&P 500 tends to bottom about four-to-five months prior to the end of a recession, not prior to one (see figure 5). So, it is good news that the market has rallied on better-than-expected earnings, increasing confidence that inflation has peaked, and falling bond yields, but it might still be too early to declare an all-clear in markets. Please see our CIO Strategy Bulletin | Attention Investors: That Was Not a Recession for additional insights.

	Average	Median
Length of Recession	281.1	209.0
Number of Days that Peak Occurred Prior to Recession	111.4	134.5
Peak Prior to Recession to Trough During Recession(%)	-32.61%	-27.11%
Days Between Peak and Trough	257	261.0
Days into Recession that Trough Occurred	170.0	117.0
Depth into Recession that Trough Occurred	51.6%	59.3%

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This table shows the S&P 500 Performance Before and During Recessions from 1929 to 2020.

What Should U.S. Investors Watch in the Week Ahead?

The U.S. economic calendar’s most important data point will be the July consumer prices index (or CPI). The consensus is calling for headline inflation to fall from 9.1% to 8.7% while core inflation increases from 5.9% to 6.1%. There is a very good chance that July marks peak headline inflation, but like the boy who cried wolf, the call for peak inflation has come and gone many times already. The other interesting report will be the University of Michigan’s consumer sentiment index. Not necessarily the headline index, but the 5-10 year inflation expectations component. If consumers’ inflation expectations ease, the market may see it as a sign that inflation is starting to trend in the right direction.

The earnings calendar will be quite heavy with the bulk of reporting on Wednesday and Thursday. Thus far, second quarter earnings have been remarkably stable with S&P 500 earnings-per-share (EPS) tracking about 7.6% higher year-on-year. That’s a full two percentage points higher than estimated just a few weeks ago….though a decent portion of that is coming from the red-hot energy sector.

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Index	Weekly Chgchange in percent	YTDyear to date change in percent	12 Months12 month change in percent	Div. Yield division yield in percent
Dow Jones	-0.1%	-9.7%	-6.4%	2.0%
S&P 500	0.4%	-13.0%	-6.4%	1.6%
NASDAQ	2.2%	-19.1%	-15.0%	0.8%
Instrument	Weekly Chgchange	YTDyear to date	12 Months12 month change	Level
10-Year Treasury Yield (%)	17.8 bps	131.6 bps	160 bps	2.83%
Gold ($/Oz.)	0.5%	-2.9%	-1.6%	$1,775.5
Oil ($/bbl)	-9.7%	15.6%	28.8%	$89.01

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This table shows returns for various USA equity markets and select assets, in weekly, year-to-date and 12 month changes.

Index	Weekly Chg change in percent	YTD year to date in percent	12 Months12 month change in percent	Div. Yield division yield in percent
Global	0.3%	-15.3%	-12.7%	2.2%
Europe	-0.9%	-19.2%	-19.3%	3.4%
Japan	-0.9%	-17.4%	-18.1%	2.4%
Emerging Markets	1.0%	-17.0%	-20.7%	3.1%

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This table shows the US Stock Market Returns and Select Assets and International Stock Market Returns.

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Date	Time	Event	Period	Consensus	Prior
8/9	6:00	NFIBNational Federation of Independent Business Small Business Optimism	JulJuly	89.5	89.5
8/9	8:30	Nonfarm Productivity	2Q P	-4.6%	-7.3%
8/9	8:30	Unit Labor Costs	2Q P	9.5%	12.6%
8/10	8:30	CPIConsumer Price Index YoY year on year	JulJuly	8.7%	9.1%
8/10	8:30	CPIConsumer Price Index Ex Food and Energy YoY year on year	JulJuly	6.1%	5.9%
8/11	8:30	PPI Final Demand YoY year on year	JulJuly	10.4%	11.3%
8/11	8:30	PPI Ex Food and Energy YoY year on year	JulJuly	7.7%	8.2%
8/12	10:00	U of Mich.University of Michigan	AugAugust P	52.5	51.5
8/12	10:00	U of Mich.University of Michigan 5-10 YrYear Inflation	AugAugust P	2.8%	2.9%

This table lists a number of key economic events, analysis reports and forecasts from influential institutions.

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