The equinox has come and gone and the end of the first quarter is near. And boy what a quarter it’s been. If lingering COVID effects were our only worry, life would be pretty good. But soaring inflation, now exacerbated by a commodities price surge courtesy of the war in Ukraine, has focused a spotlight on an aggressive shift in Fed policy and the consequent impact on markets. Policymakers lifted the fed funds rate by a quarter of a percent last week and announced the intention to reduce the size of their balance sheet sooner rather than later. The Fed Chairman subsequently emphasized the need to move “expeditiously” and act more aggressively going forward if necessary. As to market behavior, it’s been well-noted that the yield curve, particularly the maturity spectrum past two years, has shifted higher and flattened or inverted in response. It’s a moving target to be sure, but right now the sentiment that’s built into current bond yields reflects the expectation of an eventual fed funds rate of around 2.50% one year from now, a level many would view as a return to “neutral”. We’ll see if that actually plays out.
The Fed appears quite confident that the US economy can withstand a quick and decisive ratcheting-up in the cost of money to households and businesses. Indeed, that sudden upward jolt in the cost of borrowing will come right as the beneficial effects of massive fiscal stimulus fades as well. No more stimulus checks, enhanced unemployment benefits or PPP loans. And now, the cost of short-term borrowing is expected to go up tenfold. Demand destruction indeed. Not that it isn’t the right medicine for painful and persistent inflation, especially when there’s concern about inflationary psychology taking hold and driving economic behavior and decision-making. The cost of success in taming inflation, however, may well be recession, and that’s part of the explanation for the quickly flattening curve. If the economy weakens too much, the tightening process could be derailed early. As Atlanta Fed President Bostic said “The risks go both ways. Should demand falter in the face of economic uncertainty or removal of monetary policy accommodation, then the appropriate path may be shallower than currently projected”. Others on the FOMC, like James Bullard of the St. Louis Bank, are encouraging a “damn the torpedoes, full speed ahead” approach, arguing that the faster we get to restrictive policy, the better off we’ll be. All are hoping for the proverbial soft landing. Fingers are crossed.
The economic data this week showed slower new home sales and weaker capital goods orders versus expectations. Consumer sentiment was a touch weaker than estimates as well. The weekly labor market statistics, however, continued to shine. Continuing Jobless Claims are now at a multi-decade low, further evidence that the Fed is correct to focus on tightness in the labor market, and maintain their inflation-fighting diligence.
US Continuing Claims for Unemployment Insurance
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