This week the US Bureau of Labor Statistics will report an update of US inflation numbers which will probably show a small slowdown of the inflation headline number compared to last month. After last week’s shockingly strong employment numbers, fixed income markets hope to see at least a small signal that inflation pressures are cooling off. But just like the summer temperatures outside, it will take more time before the economic cycle takes a decisive turn towards softer numbers. Judging by the 500k+ payroll number and the drop of the unemployment rate to 3.5%, the interest rate tightening cycle has yet to truly damage the US economy. Taking into account that the Fed took the official rate to a neutral level of around 2.5% last month and has yet to turn restrictive, it is clearly too soon to declare an end to the rate hike cycle.
Financial markets are not very patient at the best of times and this cycle is no exception. Bond markets are acting like a bunch of children sitting in the back seat of a car which is slowly taking them towards their holiday residence. To the annoyance of their parents, the kids ask every five minutes whether they have reached their destination and the answers from the front of the car show ever higher levels of irritation. The Fed is in a comparable situation. While it is trying to navigate the economy out of a dangerous period of overheating, the only question it gets from the back seat passengers is when it will stop hiking. After the previous meeting, chairman Powell should have provided a clear answer to markets that the Fed is nowhere near done with hiking, but instead he left it to the market to guess the remaining length of the trip. That was a mistake as this allowed financial markets to think the Fed’s cycle was close to ending and even speculate that the Fed will cut rates considerably next year. The last two rate hikes of 75 basis points were meant to tighten financial conditions, but all the Fed got was a rally in bond and equity markets in July which completely negated the effect of these rate hikes.
A new mindset is needed
Since the start of August, Fed board members are trying to undo the damage of Powell’s press conference by emphasizing that the Fed is not nearly done with its tightening cycle. But a lot more needs to be done by the Fed to convince markets that it is committed to bring inflation back to a normal level expediently. Another 75 basis point hike in the September meeting would certainly help, especially in combination with a clear statement that the Fed is aiming to keep financial conditions tight for a considerable period. Such a statement will help markets to realize that any premature bond or equity market rally will just result in more rate hikes. This might not dampen the knee-jerk reaction to price in rate cuts for next year, but investors will rethink their urge to buy every dip in financial assets. Most investors are clearly still in the mindset of the previous decade that monetary policy will remain loose forever and that rate hike cycles will be shallow and short. In the coming quarters, this view will be challenged by central banks who must reclaim their credibility in fighting inflation. And we should not forget that the Fed is not the only central bank who has to sternly address the kids on the back seat. Are we there yet? Certainly not.