February FOMC Preview: Will the Fed Update its Model of the Labor Market?

What to Expect:

1. The Fed will continue moderating its pace of rate hikes, stepping down to 25 basis point hikes.
2. With favorable disinflationary data coming in from both wages and prices since the last meeting, the key question is whether or not the Fed continues to think it is necessary to break the labor market to bring inflation down. Last-minute data releases in the ECI and JOLTS will be influential, for better or worse. We will pay attention to how Powell changes his view about the relationship between the labor market and inflation on Wednesday, if at all. No change in Powell’s reasoning would suggest continued intent for the Fed to aim for recessionary unemployment increases over the next year.

The Developments That Matter:

A lot has changed in the last six weeks.

• We learned that wage pressures have been easing—not just over the last month but the last three months. In the December labor market report, we got a (relatively) soft average hourly earnings print and downwards revisions to the October and November figures.
• New price data showed continued disinflation through the end of 2022. Since the last meeting, we’ve had two months of inflation releases; annualized growth in core PCE prices in November and December was 1.9% and 3.6%, respectively, far lower than the 4.4% year-on-year change. However, inflation in core services ex housing remains high, and the Fed has assigned outsized weight to this category erroneously thinking that inflation in this category is necessarily wage-caused.
• The GDP release showed stronger-than-expected GDP growth (to the extent GDP growth feels disappointing, it’s due to aging, not productivity).
• Personal consumption expenditures in both nominal and real terms fell in November and December, consistent with the slowdown in gross labor income as employment growth declined substantially last year.
• Financial conditions have eased since the last meeting, but remain substantially tighter than a year ago.

Last Minute Labor Market Data

This week’s meeting coincides with a deluge of labor market data, and the Fed will see new data from the Employment Cost Index (ECI) release on Tuesday and JOLTS on Wednesday

• The ECI numbers, one of Jay Powell’s favorite wage measures, will come in tomorrow morning and give us a better (albeit still potentially flawed) picture of wage growth in 2022Q4. ECI-measured compensation grew around 5% in 2022 Q3, and Powell has indicated that he believes this is 1.5 to 2.0 percentage points above what is consistent with the 2% inflation target. The trend of average hourly earnings points towards a deceleration of ECI, likely coming in around 4.2%, but there are risks on both sides, especially if Powell places too much emphasis on this (or any other) wage metric.
• With tech layoffs dominating the headlines, much attention will be paid to what happens to the layoff rate. This will be important, but significant labor market softening can show up even without layoffs if hires and quits fall. The Fed will be keeping a close eye on job openings, which has come down only slightly from its 2022 peak. If it continues to come in hot, will they continue to hang their hat on this flawed metric that would have forecasted continued high inflation through 2022, or will they dial back on their emphasis on vacancies?

What We Think the Fed Should Do:

We wrote previously about how the Fed’s December projections are consistent with them trying to engineer a recession. We think this is neither necessary nor desirable, but the Fed has been operating on a framework based on three faulty premises:

• That “labor market tightness,” especially when measured by the vacancy-to-unemployment ratio, was a portent of unsustainable wage growth;
• That this wage growth would feed directly into inflation, especially in core services ex-housing, and is the primary causal mechanism for labor market dynamics to feed into current inflation trends;
• That the only way to break this chain of events is to increase the unemployment rate at a rate consistent with recessions.

Since the last meeting, new data and revisions have shown that disinflation is possible even as the labor market remains strong, since labor income growth is slowing and returning to its pre-pandemic growth rate. We hope the Fed recognizes that it has been operating on a faulty model of the labor market’s relationship to inflation and adjusts accordingly by signaling that it no longer sees the above chain of events as the primary description of what drives inflation. Before the last meeting, we wrote that the risks to the outlook are “increasingly balanced.” Since then, the inflation-side risk has subsided substantially, and the Fed should look to loosen financial conditions accordingly.

Latest Fedspeak

Charts: Financial Conditions

Charts: Wages and Labor Income