The markets have fully discounted a 25-bps reduction in Fed Funds at next week’s FOMC meeting. Based upon the most basic definition is monetary policy is restrictive; inflation around 3% and the overnight rate at 5.25%, thus suggesting 225 bps of easing to have monetary neutrality.
The 2-year Treasury has fully discounted such to occur. Is this realistic? Has inflation subsided to this level or is there a risk of reacceleration?
As widely acknowledged, the primary determinate of monetary policy is now employment and wages. Cost push inflation or wage inflation is now imbedded. To overcome cost push inflation either more supply must come online, or the economy experiences a crushing recession like the ones of the early 1980s, the last time cost push inflation was imbedded.
The labor participation rate (LPR) of 62.7 is nominally higher than the COVID lows of 60.2% but considerably lower than the 66.1% level experienced in the years before the Great Financial Crisis (GFC) and the 63.5% level immediately prior to COVID.
For whatever the reason, and the explanations are controversial as to why including government statistics indicating that some are paid more not to work rather than to work, the labor participation rate has not fully rebounded. If it rebounded to the pre COVID levels, the supply of available workers would be greater than pre COVID. A dated BLS study suggested if the LPR returns to the pre GFC range, unemployment would have an “eight handle.”
Depending upon the poll, immigration is either the top or the second highest concern of voters. A strong argument can be made that US companies need workers to fill their rolls to lower their labor costs and remain competitive. A cheaper pool of workers is available south of the border.
It some regards the environment is similar to the environment at the verge of German reunification 35 years ago. High-cost West Germany was able to significantly lower its production costs and increase productivity and competitiveness when it absorbed the low-cost workers from East Germany via reunification.
During last night’s debate, immigration was discussed. It is dangerous to touch the third rail of politics, but it is almost impossible to keep politics and economics unlinked as they are interwoven.
Some would state the open borders is an attempt to tip the voting demographics to favor one party over the other. An issue with this viewpoint is that during this election cycle, Latinos are perhaps breaking for the Trump given his more traditional views on several social issues, the inverse of the accepted or preconceived path.
Will this possible misjudgment be viewed in a similar light as the decline of the EV market, which may soon be regarded as Edsel on steroids?
Continuing with the discussion about the direction of interest rates, the two-year Treasury or the instrument most sensitive to monetary policy has fully discounted almost 175 bps of easing. What happens if the expecting easing does not occur?
What is perhaps most interesting is based upon recent data from the Treasury Department, the Treasury has been selling shorter dated Treasuries (defined as two years or less) and purchasing longer dated Treasuries (defined as 10 years or more).
The net effect of Treasury’s activity—borrowing more at the short end, injecting liquidity into the long end—is to push long term interest rates lower. It is a form of economic stimulus which might be ok but could also add inflation pressure…just as the Fed thinks it has inflation on the run
The Treasury may also be believing that demand for short-term notes will remain robust and the funds in money market accounts will not gravitate into equities as Goldman suggests when or if rates decline.
Perhaps the bigger point is not only the Fed but also the Treasury is working to push interest rates in a desired direction, but not necessarily in the same direction.
Wow! Perhaps this is another example of life is stranger than fiction. No wonder many believe the future is extremely opaque.
What will happen today? The CPI is released at 8:30. The market is expecting a 0.2% increase on both the headline and core rate.
Last night the foreign markets were mixed. London was up 0.20%, Paris up 0.38% and Frankfurt up 0.51%. China was down 0.82%, Japan down 1.49% and Hang Seng down 0.73%.
Futures are nominally lower ahead of the CPI. The 10-year is up 6/32 to yield 3.61%.
