Riding the Economic Rollercoaster: How Persistent Job Growth Influences the Federal Reserve’s Restrictive Stance

The U.S. economy is currently facing a significant challenge: a delicate dance orchestrated by the Federal Reserve aimed at tempering inflation while promoting growth. Despite a weakening GDP and slowing consumption, persistent job growth has kept the Fed steadfast in its restrictive approach to monetary policy.

The tightening monetary policy and a series of interest rate hikes—500 basis points thus far, with potential for more—are designed to combat inflation, but they may lead to further pressure on consumer spending and economic activity. As the market grapples with these measures, it has to cope with a potential slide into a stagflation scenario—an economic state characterized by slow growth and high inflation.

While the overall inflation rate remains high, it has shown signs of moderating. The Fed’s preferred inflation metric, the core PCE, sits at a disconcerting 4.6%—more than double the 2% target. To mitigate these inflationary pressures, the Fed is expected to raise the federal funds rate from its current 5.13% level. Market participants anticipate a 25-bp hike at the July meeting, pushing the terminal rate to 5.38%. However, the Fed projects another potential rate hike, implying a terminal rate of 5.63% by the year’s end, an outcome the market deems less likely with only a 28% probability assigned.

The Fed is not only utilizing interest rates as a policy tool but has also amplified its balance sheet reduction program. Raising the monthly cap from $47.5 billion to $95 billion, this policy change further constricts the money supply and tightens financial conditions. However, recent bank troubles led the Fed to inject $392 billion into the economy via the emergency Bank Term Funding Program. Despite this measure, the balance sheet has contracted to a new cycle low, and the Fed remains committed to maintaining higher rates until it sees credible signs of inflation returning to the 2% target.

With tightening lending conditions likely to stifle economic and employment growth, the picture is complex. The lending contraction experienced in the week ending March 22nd marked the sharpest decrease since the 2008 financial crisis, an indication of significant stress within the banking sector.

Assessing the broader economic landscape, a handful of leading indicators provide vital insights.

The labor market is demonstrating early signs of strain as a consequence of higher interest rates and declining consumer spending. Initial unemployment claims have risen sharply amid slower revenue growth, weakening margins, and tightening financial conditions. While some companies continue to hoard labor due to hiring challenges and labor shortages, others, particularly in the tech sector, have implemented layoffs and hiring freezes.

Retail sales, a robust reflection of consumer behavior, have decelerated as economic conditions weaken. Higher prices, tighter financial conditions, and fewer job openings are constraining consumers, with retail sales contracting in many recent months, particularly for goods. As the Fed persists with monetary tightening and fiscal stimulus remains limited, we expect further deceleration in consumer spending.

The housing market, another significant component of the economy, is experiencing a sharp decline as well. The affordability of homes is at near-historic lows, due to high prices and high mortgage rates, causing a reduction in building permits. As demand for housing outside urban areas subsides and financial conditions tighten, this contraction is likely to persist.

Manufacturing activity has followed a similar trajectory. The sector, typically susceptible to interest-rate movements, is showing depressed demand, particularly for big-ticket items, and has been in contraction territory for most of the past eight months.

Furthermore, the yield curve, currently in a deeply inverted state, signals potential economic contraction ahead. The 2-year yield has risen faster than the 10-year since January 2022, indicating that the market perceives limited chances for the U.S. economy to handle the monetary tightening without recession.

In light of these complex dynamics, the Fed’s restrictive stance has its work cut out. Persistent job growth, against the backdrop of a robust labor market, is a positive, but it’s countered by the myriad of negative indicators, including a contracting money supply, lower demand, lower GDP growth, and a threatening stagflation scenario. As the economic landscape evolves, these indicators will continue to serve as crucial markers for anticipating the direction of the economy.

As we move further into 2023, the onus lies on the Federal Reserve to balance its commitment to controlling inflation with the growing risks to economic growth and job creation. It’s an unenviable position, but one that they are better equipped to handle than most. With the hope of a return to normalcy after the disruptions of the COVID-19 pandemic, all eyes will be on the Fed’s next moves and the impacts they’ll have on the economy’s trajectory. The challenge is considerable, but so too are the opportunities for robust economic stewardship.

By: Jose Torres, from Interactive Brokers