When choosing the monetary policy stance, central banks from all over the world take into account just two main factors. These are changes in the general price level in a particular economy and labor market conditions. Both of them are perfect indicators of the overall economic situation. What is more, these indicators allow analysts to predict future economic trends. By altering the key interest rate, monetary authorities attempt to shape these trends so that they develop according to a more favorable scenario.
Interest rates have a significant influence on markets. There are several reasons for that. Most large investors, namely various banks and funds, trade by means of the funds received from their depositors and clients. In other words, they use borrowed money instead of their own savings. Notably, both in the US and Europe, such agreements are made at floating interest rates instead of fixed ones. Floating interest rates are based on the key rate. For example, a bank has attracted its client’s funds at the 2.00% interest rate, whereas the benchmark rate totals 3.00%. If the central bank raises the key interest rate to 3.50%, the bank will have to return the funds to its client at an interest rate of 2.25%-2.75%. In other words, the bank’s cost of funds will increase, thus forcing it to reevaluate its positions and reduce or even close some of them. That is why changes in the key interest rate have a considerable influence on all the markets, including the currency, stock, and even commodity ones.
Thus, there is no wonder that the upcoming FOMC meeting is of vital importance. Notably, the Federal Reserve is planning to slacken the pace of the key interest rate hike. This decision will have long-term consequences for markets. Now, the likelihood of a soon end of the monetary policy tightening could become even higher.
This is how most traders see the current situation.
However, there are several peculiarities.
Let us start with the fact that inflation began surging in March of 2021. Then, it jumped to 2.6% from 1.7%. However, the US regulator ignored this. In May, the inflation rate reached 5.0%. Fed policymakers explained the inflation growth by tough quarantine measures in China and supply disruptions, which led to shortages. What is more, the regulator reassured people that high inflation was just a short-lived phenomenon. Such explanations somehow alleviated concerns. In addition, inflation remained stable for another five months. However, in October, it climbed to 6.2%, whereas at the end of 2021, it jumped to a stunning 7.0% by American standards. It was last autumn when the Fed started preparing markets for the key interest rate hike and long-lasting monetary policy tightening, which has begun this year.
Interestingly, aggressive rate hikes did not help the Fed cap soaring inflation. It remained stubbornly high. In June 2022, consumer prices accelerated to a 4-decade high of 9.1%. After reaching that all-time high, inflation started gradually declining. For this reason, analysts believe that the regulator could slow down the monetary tightening cycle as there have been signs of a drop in the CPI. Some of them suppose that the Fed might completely abandon a hawkish stance, which would be great news for investors.
However, there has been no steady decline in consumer prices. They are still unacceptably high. Therefore, the central bank keeps raising the key rate. Naturally, a slowdown in inflation may lead to smaller rate hikes but that’s it. This is why the regulator will continue to tighten monetary policy at least until the middle of next year.
When assessing economic prospects, analysts pay greater attention to inflation, completely overlooking the labor market. However, the situation with the labor market is rather curious.
Despite galloping inflation and a looming recession, the unemployment rate is almost at its lowest level in fifty years. It clearly signals an overheating of the labor market, which may lead to devastating consequences.
The Fed has been strongly committed to ultra-loose monetary policy for quite a long period of time. It bolstered a surge in investment, enabling companies to expand thanks to low borrowing costs. Businesses also took loans and invested, among other things, in the creation of new jobs. The problem is that such investments have a fairly long payback period. If there is a labor shortage, which happens at an extremely low unemployment rate, businesses face a very serious challenge. Companies have attracted the necessary funds for their development but they need to return them later. If they want to get profit from their investment, they should hire more workers. However, it is rather taxing given that it is almost impossible to find suitable employees. Of course, firms can lure employees from other companies with higher salaries. Such an approach increases costs and reduces profits. The payback period becomes even longer. As a result, companies cannot generate profit. At some point, it will be easier for a business to deduct losses and start cutting costs. Otherwise, they will go bankrupt. In turn, it will result in job cuts and mass layoffs. It might become another reason for a protracted and rather deep recession.
Thus, the regulator needs to raise rates to avoid such a scenario.
Given the peculiarities of the US labor market and the high labor mobility, the acceptable unemployment rate is considered to be 5.0%. Currently, it stands at 3.7%. There are also no signs of its steady growth. It means that there is still a chance that the central bank could hike the interest rate by 75 basis points. Such an increase may catch many market players off guard.
Apparently, investors’ hopes for a pause in the monetary tightening cycle look more like a fantasy. They are constantly looking for dovish signals. Traders still believe that the Fed could move away from aggressive tightening and return the cash rate to the zero level in the near future. However, judging by the labor market situation, there will hardly be any shift from aggressive rate hikes at least until the middle of next year. They will remain at a relatively high level until the labor market stabilizes and there is no risk of overheating.
At the start of next year, the Fed may adjust its medium-term plans for monetary policy. Those who have been betting on a dovish stance could be rather disappointed. The comments of Fed policymakers also point to such a scenario. They have mentioned quite often the current situation in the labor market when speaking about monetary policy prospects.
