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Issue 15: Can the Fed Achieve Mission Impossible?

January 17, 2023

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Can the Fed achieve ‘mission impossible’: a soft landing?

What does recent data tell us?
December nonfarm payroll data, reported at the beginning of January by the Bureau of Labor Statistics (BLS), was in line with expectations and the unemployment rate fell back to a 50-year low, signs of the US labor market’s profound strength—typically seen as a textbook source of inflationary pressure. Such concerns were mitigated to a degree by one other bit of jobs data that seemed to catch investors’ attention: an average hourly earnings figure that saw its smallest increase since August 2021, both on a month-over-month and year-over-year basis, printing well below a 5% increase forecast by many economists. That number is still undeniably high relative to the Fed’s comfort zone, though we must admit it is moving in the right direction. Of course, the Fed’s monetary tightening has been explicitly aimed at achieving a looser labor market and the corresponding slowdown in wage inflation, so Jay Powell would tell us this was all part of the plan. Taken together, such data suggests at least a possibility that the Fed manages to cool the economy without a disruptive increase in unemployment or a nasty recession. Recently released ISM numbers provide more evidence that despite a strong labor market and robust consumer health, things are slowing down, as the services sector was seen dipping into contractionary territory with a reading below 50.


Don’t underestimate risk of the Fed overshooting
In response to data like this—and what we see as some decidedly glass-half-full interpretation of the numbers—the beginning of 2023 has witnessed a “soft landing rally”, with still-hawkish Fed pronouncements barely making a dent in the markets’ optimism on the outlook for rate cuts by the second half of the year. On the day of the aforementioned BLS report, for example, the market moved to price nearly three rate cuts over the next twelve months. Investors would do well to remember that the Fed is still in the driver seat and is dead set on avoiding a second surge in prices. It has the power to achieve whatever financial conditions it requires to slow growth, push up unemployment, and bring down inflation. If markets don’t follow the Fed willingly, the Fed has signaled that it will force the issue. While a soft landing would be the best outcome, the likelihood of a ‘policy error’ still looms, with one of the biggest risks to the economy an overshoot by the Fed.


Committing to tighter conditions
The Fed’s professed extreme commitment to vanquishing inflation makes that risk greater. Facing the strongest surge in inflation in four decades, the Fed entered 2022 massively behind the curve. In under a year they’ve lifted policy rates by 425 bps and initiated quantitative tightening (QT). With memories of 1970s-style inflation still burning in the brains of US policy-makers, they are exceedingly cautious about taking their foot off the brakes too early. Indeed, to ensure inflation is fully under control, the Fed committee has suggested it won’t put too much weight on so-called ‘leading indicators’ that might give early warning of policy success. In other words, the Fed is signaling that even if data weakens or risk assets decline in anticipation of a slowdown, they will not immediately reverse course. Markets seem not to take heed of the central bank’s commitment, as risk assets begin to price a future in which inflation has faded, the Fed’s work is done, and we can enter the next easing cycle. Given the Fed’s stated goal of tightening financial conditions to stifle demand and cool the economy, a look at Goldman Sachs Financial Conditions Index, below, shows conditions actually loosening marginally since October—not what the Fed wants to see, to be sure.

Figure 1 Goldman Sachs Financial Conditions Index

Quick thoughts on China’s reopening

How is China’s pivot from zero-COVID progressing?
The past year was something traders call a ‘single-risk market’, in which investment decisions mostly centered on one thing: the Fed’s battle against inflation. China’s abrupt decision to ditch zero-COVID policies in favor of a long-awaited—if not fairly chaotic—reopening of its economy promises to make the next twelve months a bit more multifaceted. While many pundits (ourselves included) expected China to phase its departure from stringent public health measures, a rushed shedding of zero-COVID protocol unleashed a wave in cases across the country that muddies the waters for those charting China’s rebound from disastrously slow 2022 growth. Among data we are tracking, activity on China’s most popular search engine, Baidu, has shown a peak in COVID-related searches; if our experience with Google search results is any indication, this likely suggests new COVID cases will be on the decline. As China’s reopening continues, hectic as we expect it will be, demand will soon return and Chinese consumers will begin spending some of their large precautionary savings. Beijing’s bid to stoke a rebound with highly supportive policies in the tech and property sectors will also start gaining traction this year (particularly, we expect, after Xi’s new government officially assumes control in March).


Reopening is an inflationary wildcard—but also a chance for diversification
China’s return to growth will obviously have an impact on inflation, which is something that is no doubt on the Fed’s mind. Global investors will see this, among other places, in China’s demand for commodities coming back online, which will exert upward pressure on prices, as we’ve mentioned before. Based on research by Goldman Sachs, China’s oil demand has been climbing in the past few years, and reopening will likely add around 1 million barrels per day to demand, corresponding to 1% of global oil demand. While that may seem small as a percentage, it’s estimated that a 1% increase in demand could move global oil prices by up to $5 dollars per barrel. Although this might be bad news for inflation, seeing China’s reopening kick off just as the rest of the world slows down also suggests a diversification story is at play here. With the MSCI China index sitting at 11x forward earnings, this seems like a good bet for investors seeking to hedge a global downturn with exposure to an inherently high-growth economy poised for a bounce back.