BUCKLE UP: SIGNS NOW POINT TO HIGHER RATES -- AND A HARDER LANDING / BARRON´S MAGAZINE

Buckle Up: Signs Now Point to Higher Rates—and a Harder Landing

By Megan Cassella

A spate of recent data is telling the Fed it has to go higher, and will probably have to raise interest rates beyond the 5% terminal rate they had previously forecast.

The Federal Reserve’s heavily telegraphed move to slow its pace of monetary-policy tightening next week risks sending a message to markets that the central bank is well on its way to reining in inflation and guiding the economy to a soft landing. 

Investors would do well to re-evaluate.

Regardless of the Fed’s pace of monetary-policy tightening, the more consequential message the economy is sending now is that the central bank probably will have to raise interest rates beyond the roughly 5% range that markets are expecting in order to wrestle the current bout of inflation back closer to its target level. 

And that, in turn, suggests that at least a mild recession looks increasingly necessary for prices to finally cool off.

“We’re headed for a hard landing. 

And it’s a tough story to sell because the data look good,” says Aneta Markowska, chief financial economist with Jefferies. 

“That’s going to change.”

The optimist camp argues that the combination of October’s mild cooling in the consumer price index, the subtle drop in labor demand, and the Fed’s own downshift suggest that the economy is softening in all of the right ways, reacting to tighter policy without dropping off a cliff. 

But what this argument misses is how much further inflation and the labor market must fall—and how painful that drop will be.

Consider first the persistent strength in the country’s services sector. 

New information released this past week showed growth in the services sector unexpectedly accelerating in November, as resilient consumers continued to spend. 

It pushed services activity to a level that, as Citi economists put it, “raises the prospects of higher-for-longer rates regime again,” given that services inflation is unlikely to slow soon.

The producer price index, released on Friday morning, also came in hotter than expected and showed services prices accelerating, even as goods prices slowed.

With the services sector running hot, the share of workers quitting their jobs, which had been falling, is now leveling off in two key services industries that had driven much of the Great Resignation, according to an analysis of government data by Nick Bunker, economic research director with the Indeed Hiring Lab.

Bunker found that the so-called quits rate in the retail sector has leveled off, while in leisure and hospitality the rate has begun to rise again. 

That matters because economic research has shown that an increased share of workers quitting their jobs can put upward pressure on wages, as employers compete to hire and retain employees.

And wages have indeed begun to heat up. 

Average hourly earnings climbed 0.6% last month and have accelerated in each of the past three months, knocking down nascent hopes that earnings were cooling off.

While some analysts had pushed back on concerns that wages were rising—suggesting that much of the increase in November was due to a less concerning drop in hours, rather than a jump in pay—a separate measure released on Thursday underscored that earnings continue to climb: The Atlanta Fed’s wage growth tracker showed wages accelerating last month to a 6.2% annual growth rate in November from a 6% pace the month before.

The various ways to measure earnings now “are all telling a consistent story,” says Harvard University economist Jason Furman. 

“No moderation in wage growth.”

For the Fed, rampant wage growth is worrisome because it fuels inflation in the services sector, where prices continue to soar, even as other sectors begin to see some relief. 

That forces the central bank to keep rates higher for longer in an attempt to bring down demand.

But there’s a second consequence that could be just as destabilizing. 

The higher that wages rise, the more they will cut into the profit margins of small businesses that have been powering the labor market and are responsible for the vast majority of current job openings, says Markowska. 

She points out that the share of small-business owners raising wages is climbing at the same time that the share that is raising prices is collapsing, according to a recent survey from the National Federation of Independent Business. 

“That margin space that was created by pricing power and the fact that wages were lagging—that is about to reverse,” she says.

Markowska sees small-business profits coming under pressure in the first quarter of next year, especially as companies make cost-of-living adjustments in January that could push wages higher. 

That, in turn, can prompt businesses to pull their job openings and lead to a layoff cycle, she says. And suddenly, the labor market is stumbling, even as inflation remains far above target.

Viewed that way, rising wages can quickly undercut the two pieces most crucial to engineering a soft landing: falling inflation and a steady labor market. 

The Fed needs both, and soaring worker pay could mean that the central bank isn’t close to getting either.

All of which suggests that a hard landing, and a recession, is more likely than markets expect. 

And the longer that equity investors remain optimistic, the more damaging the fallout could be. 

“That’s another mechanism through which a potential recession could deepen, as it finds its way into markets,” Larry Summers, the former Treasury secretary, tells Barron’s.

Summers warns that with an economic downturn all but inevitable, in his view, there’s “significant risk” that the Fed will cut interest rates even before inflation falls back to its 2% target. 

While that could help the economy in the near term, it could also backfire by requiring a second, possibly more damaging, round of rate increases shortly thereafter.

The result could be something akin to former Fed Chairman Paul Volcker’s experience in the early 1980s, when the central bank began cutting rates in response to recession only to lift them back even higher when inflation began to level off.

“We are all taught that when the doctor prescribes us antibiotics, we’re supposed to take the whole course,” Summers says. 

“But very often, people take only partially the course of antibiotics until they feel better, or feel some side-effects, and then they have to go back on the medicine.”