A year ago, Gang Hu, an inflation trader at New York hedge fund WinShore Capital Partners, delivered a remarkably accurate prediction. He stated that inflation would demonstrate a stubbornness that most people fail to recognize. Today, Hu raises another concern: financial markets might be trapped in a “self-defeating feedback loop,” which increases the likelihood of the Federal Reserve continuously raising interest rates.
Hu’s argument revolves around a single point: successfully curbing inflation will likely necessitate a recession. Without an economic downturn, the structural factors that contribute to inflationary pressures will persist, and public expectations for long-term inflation will become uncontrolled.
The feedback loop begins with the market’s current belief that the Federal Reserve will halt their rate hikes near the current level of 5%-5.25%. However, the central bank’s apprehension about losing control over inflation expectations pushes policymakers to adopt a “hawkish” stance to protect their credibility. Consequently, investors and traders respond by factoring in more potential rate hikes in the future. Eventually, these cautious communications translate into real actions as the Fed and other central banks cannot afford to surprise markets by not taking proactive measures.
Hu’s analysis sheds light on the complex dilemma facing financial markets. If we are to tackle inflation effectively, we may need to confront the possibility of a recession. This stark reality challenges policymakers to navigate a delicate balancing act, carefully managing public expectations while avoiding an economic downturn.
As we delve deeper into the intricacies of economic dynamics and policy decisions, it becomes evident that there are no simple solutions. The path forward requires a nuanced understanding of both short-term fluctuations and long-term structural forces. Only then can we hope to achieve stability in our ever-evolving financial landscape.
U.S. Jobs Report and Federal Reserve Minutes Indicate Potential Inflation Concerns
The U.S. jobs report for June, along with the Federal Reserve’s most recent minutes, raises questions about potential inflationary pressures. Despite job gains falling below expectations at 209,000 for last month, the report showed a positive increase in average hourly earnings, with a rise of 0.4% for the month and 4.4% over the past year. According to experts, such as Hu, these wage increases are part of the “multiple structural forces” that continue to contribute to inflation surpassing the Fed’s 2% target.
The minutes from the Fed’s June 13-14 meeting, which were released recently, highlight the concerns some policy makers have about the possibility of long-term expectations becoming unanchored. Additionally, a few officials expressed worries about upside risks to the outlook for housing services inflation, while many policy makers agreed that price gains in core goods were not declining quickly enough.
Hu emphasizes that the discussion around higher structural inflation, potentially exceeding 2%, has gained significant attention recently. If these concerns are validated, it may require more aggressive action from central banks to combat inflation, potentially even an economic recession. However, Hu clarifies that this issue is not confined to just a few months; it is a reflection of long-term trends in inflation and public perception regarding its persistence.
Considering potential scenarios, if the central bank were to cease raising rates at around 5.25% to 5.5%, it would essentially communicate that it believes current measures are sufficient to control inflation.
Read: Why stock-market investors find wage data in the June jobs report unsettling
Economic Optimism in the Stock Market
As of Friday afternoon, stocks were on the rise following the release of the June jobs report. This report came on the heels of a strong private-sector jobs reading that caused concern among investors and rekindled fears of a rate hike. However, the market seems to have found some relief as Treasury yields and rate hike expectations pulled back slightly.
The 5-year, 5-year rate from the inflation swaps market, which reflects intermediate-term expectations, remained steady at its recent range of 2.66% over the past year. This suggests that market participants are retaining optimism about future economic conditions.
Chris Low, chief economist at FHN Financial in New York, described Friday’s nonfarm payrolls report as a “win, win, win.” Furthermore, Chicago Fed President Austan Goolsbee stated that the labor market is moving towards a “balanced, sustainable path.”
However, not everyone shares this positive sentiment. Chris Ainsworth, chief executive of Pave Finance in New York, believes that the Federal Reserve is still falling short of its goals. According to Ainsworth, inflation remains above the Fed’s 2% target, and the compounding effects of high inflation may not be fully realized until later this year. This increases the risks of a deeper-than-expected recession.
Despite differing opinions, the stock market remains optimistic in the wake of the June jobs report. Investors are keeping a close eye on economic indicators and the Federal Reserve’s actions as they navigate the second half of 2023.
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U.S. Inflation Update for June: A Welcomed Decline
Next week, on Wednesday, we can anticipate the release of the month’s significant U.S. inflation update, the consumer-price index for June. Traders involved in derivatives-like instruments called fixings are predicting a decline in the annual headline CPI rate, expecting it to come in at 3%. This is a drop from the 4% recorded in May and significantly lower than the peak of 9.1% observed in June of last year.
The fixings market shows that there is an assumption of a 0.2% monthly increase in core inflation for both June and July, based on Hu’s own model.
Investors can breathe a sigh of relief with this knowledge. However, it’s worth noting that Hu emphasizes the Federal Reserve’s desire to ensure that inflation expectations are securely anchored. This precaution is taken to avoid surprising the market, as seen with the Bank of England’s unexpected half-of-a-percentage-point hike in June, and the Bank of Canada’s resumption of rate hikes in June after pausing in April and March.
The State of the U.S. Economy and Inflation Expectations
The current state of the U.S. economy does not show any signs of a recession, according to experts. Despite concerns about inflation becoming a long-lasting trend, market indicators suggest that inflation expectations remain stable.
Although this situation may cause some unease at the Federal Reserve (Fed), there is no conclusive evidence to support the need for immediate action. However, if the economy experiences a delayed slowdown, the Fed may be compelled to implement aggressive rate hikes.
It is important to note that the recent nonfarm payrolls data for June was not weak in any way. Therefore, the Fed is still likely to proceed with a rate hike in July. Depending on how inflation evolves, there may be further rate hikes in November as well.
In comparison to the past, where the Fed stopped at a 5.25% interest rate in 2006, the current private-sector balance sheets are significantly stronger. This improvement suggests that the economy could potentially withstand higher fed funds rates. It appears that this is the direction in which the Fed is currently headed.
Overall, while there are discussions surrounding inflation and its potential impact on the U.S. economy, there is no imminent cause for alarm. The situation remains under close observation and will be dealt with accordingly by the Federal Reserve.