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The Fed Is on a Collision Course With Investors. What to Expect.

Barron's · 01/06/2023 20:24
By Randall W. Forsyth

Credibility gap. For those of a certain age, that term harks back to the Vietnam War era, when the government's version of the conflict varied significantly from what was happening on the ground.

The Federal Reserve might have its own credibility gap, but instead of sugarcoating the economic situation, it insists that it will maintain a tight policy to push down inflation to its 2% long-term target. That tack is justified by what the central bank officials see is a tight labor market and persistent upward pressure on prices, notably of services, excluding housing measures (which tend to lag behind current conditions).

Contrary to Fed officials' projections, markets expect short-term interest rates to rise less and then to begin to ease, in response to signs of more benign wage pressures and portents of a deceleration from the economy's current cruising speed. So markets drove bond yields lower and stock prices higher in the first week of the new year, marked by 2%-plus jumps on Friday in the major equity averages.

Central bank policy makers project further increases in the key federal-funds target rate, to a median 5.1% by the end of 2023. But, according to CME FedWatch, the fed-funds futures market sees increases of just 25 basis points (one-quarter of a percentage point) from the current 4.25%-4.50% target range at the Fed's next two policy meetings, which end on Feb. 1 and March 22.

From that plateau of 4.75%-5%, the futures market projects a dip as early as the Nov. 1 meeting, to 4.50%-4.75% -- roughly 50 basis points below the Fed's year-end projection.

The expectation gap widened in the past week, despite an array of Fed speakers insisting that they would stay the course. In particular, the employment report for December, released on Friday, bolstered notions of the fabled soft landing. It showed a stronger-than-expected rise in nonfarm payrolls and a drop in the jobless rate to a historic low, but a slowing in wage gains.

Yet Fed officials will continue to emphasize their narrative, says Vincent Reinhart, chief economist and macro strategist at Dreyfus and Mellon. Their biggest worry is that financial conditions won't be tight enough to slow spending. "They've got their story line, but markets won't cooperate," he commented in an interview following release of the jobs data.

The report showed that nonfarm payrolls had topped economists' estimates for the ninth straight month, he noted, with a 223,000 gain, versus a consensus guess around 200,000. Average hourly earnings fell short of forecasts, with a 0.3% rise in December, versus the 0.4% expected, following November's downwardly revised 0.4% increase, originally estimated at 0.6%. Measured from a year ago, average hourly earnings were up 4.6%, versus the 5.0% estimate.

But Citigroup chief U.S. economist Andrew Hollenhorst writes that the market is wrong to infer a cooling labor market from the jobs report. The household survey showed a 717,000 surge in employment, which brought the jobless rate to a 52-year low of 3.5% (3.469% before rounding).

For the financial markets, the consensus outlook of a weak first half of 2023, followed by a robust second-half rebound powered by a Fed pivot, is the exact opposite of the pattern expected by Doug Peta, chief U.S. investment strategist at BCA Research. His view: There's an underestimation of how persistent strength is, notably from the unspent fiscal stimulus of the past two years, which should make for a strong first half, both for the economy and the stock market. Eventually, however, that cache will be tapped out and the lagging effects of Fed tightening will catch up, resulting in a slump later in the year.

To guide policy, the Fed will look beyond the latest jobs numbers that heartened the bulls. The December consumer price report, due on Thursday, will be closely watched. Core prices (excluding food and energy) are expected to be up 5.7% from their level a year ago, versus 6.0% in November, according to Joshua Shapiro, chief U.S. economist at MFR. Fed officials will concentrate more on the Employment Cost Index, which Citi's Hollenhorst sees showing wage growth continuing at a disconcertingly high level.

After its failed "transitory" inflation forecast of two years ago, the nation's central bank has to close its credibility gap. For now, its dual mandate (high employment, low inflation) makes its course unequivocal. Inflation is far above its 2% target, while the jobless rate is at a historic low and below the Fed's estimate of full employment. Still, the markets remain skeptical that Jerome Powell & Co. will keep tightening.

Write to Randall W. Forsyth at randall.forsyth@barrons.com

(END) Dow Jones Newswires

January 06, 2023 20:24 ET (01:24 GMT)

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