FED RECAP: The Markets Lead the Fed

On Monday, we offered the following forecast of what would happen at the FOMC meeting today:

On Wednesday, the Fed will reduce its target rate for fed funds by 0.25%. Thatdecision will lower the federal funds target to 4.50%. This is the third move in a rate lowering cycle that began with the Fed’s 0.50% rate cut on September 18, 2024.

Here’s What Happened

The Fed did cut the fed funds rate by 0.25% as we predicted. This brings the Fed’s target rate to 4.50%. That rate cut was widely expected. The Fed does not like to produce surprises if they can possibly avoid it. This is the no drama Fed.

The Fed’s press release issued at 2:00 pm ET today did not have any content of note and was basically a restatement in technical jargon of the fundamental policy move – a rate cut of 0.25%

This meeting included the “dots,” technically the Summary of Economic Projections (SEP) offered by 19 Fed governors and regional reserve bank presidents and presented in graphical form as a dot plot. The dots show individual forecasts of key variables such as unemployment, interest rates, inflation, and economic growth. The dots do not deserve serious attention as forecasting tools. The Fed has the worst forecasting record of almost any institution.

Powell’s statement before taking questions from reporters and his answers to most of the reporters’ questions were largely a replay of the November FOMC meeting. Powell continued to put the emphasis on what he called normalization.

In his view, inflation is normalizing (meaning it’s moving toward the Fed’s 2.0% goal) and labor markets are normalizing (meaning unemployment is going up but not quickly and not by much). In this world, there’s nothing for the Fed to do except stay the course with 0.25% rate cuts unless there are material changes in the economy.

Powell Will Stay Put (For Now)

Reporters again made reference to the question of whether Donald Trump is likely to fire Powell or pressure him to resign. Powell’s term as Chair expires in early 2026 so he’s not around that much longer in any case. Since the election, the Trump transition team has said publicly that Trump will not fire Powell.

Still, Trump will almost certainly not reappoint Powell in 2026 and will be free to choose his own Chair. It may be politically convenient to keep Powell around in the meantime because the White House will have someone to blame if the economy heads south early in Trump’s term as it well may.

Most of Powell’s press conference focused on the policy dilemma we highlighted in our pre-meeting report on Monday. The Fed’s “dual mandate” requires the Fed to maintain price stability and create jobs at the same time. This is practically impossible to do on a consistent basis. There is no strong correlation between interest rates and employment.

There are times when the Fed will want to raise interest rates to fight inflation. That might hurt job creation. There are other times when the Fed might want to lower interest rates to boost employment. That might trigger inflation. Or not.

In the late 1970s, we had 10% unemployment and 15% inflation. In 2012, we had zero interest rates but unemployment was 7.9%. There is no tight correlation between jobs and inflation. In practice, the Fed has to choose one part of the mandate at a time and focus on it, leaving the other part on its own.

The U.S. payroll report from the Bureau of Labor Statistics (BLS) released on December 5 was hailed because it showed 227,000 new jobs created in November, well above expectations. But that headline masked a mountain of bad news.

The new jobs were created according to the establishment survey, which contacts businesses and has highly dubious assumptions about new business creation and seasonal adjustments. But the BLS also conducts a household survey that contacts individuals to ask if they have recently been hired or have quit or been fired. The household survey also gauges the labor force participation rate (LFPR), which measures the size of the workforce relative to the working age population. Both measures had negative results.

The household survey showed the labor force lost 355,000 jobs in November. That’s a difference of 582,000 jobs between the employment survey (+227,000) and the household survey (-355,000). The two surveys should produce similar results subject to normal statistical noise and small leads and lags.

A difference of this magnitude means that one of the surveys is badly out of sync with the real economy. History shows that when the two surveys diverge, the household survey tends to be more accurate and the employer survey sooner than later plunges to converge with the household survey. On this basis, it appears the U.S. economy is already in a recession and the headline data is struggling to catch up with the reality.

The household survey also shows that the LFPR has declined from 62.7% in September to 62.6% in October and now to 62.5% as of November 2024. All of those readings are historically low, and the persistent downtrend shows that working age individuals are dropping out of the labor force in part because they are discouraged about their prospects for finding a job.

Inflation Is Not Cooperating

Inflation is the other half of the dual mandate in addition to unemployment. After a long period of stubbornly high inflation, inflation seemed to be coming under control and heading toward the Fed’s 2.0% target. That narrative just exploded in the Fed’s face.

Here’s the tale of the inflation tape using the Consumer Price Index on a year-over year basis:

(The CPI data for December 2024 will be released on January 15, 2025).

Inflation, which peaked at 9.1% in June 2022 had been coming down steadily. The trend from March 2024 to September 2024 showed a drop from 3.5% to 2.4%. That trend was heading toward the Fed’s goal of 2.0% inflation.

The trend reversed suddenly in October 2024 when inflation rose to 2.6%. It then rose further in November 2024, hitting 2.7%, the highest rate since last July. By itself, this is not a catastrophe. The increase in inflation over the past two months may indeed prove transitory but there can be no assurance of that as of now.

The PPI Shock

The inflation story delivered another shock on December 11 when the government reported that the Producer Price Index (PPI) (a measure of wholesale price increases) rose 3% in November on a year-over-year basis. That was the highest monthly increase since February 2023. The core PPI (excluding food and energy prices) rose in November by 3.4%, even higher than the full index. The PPI increases are not only bad news on their face, but they are also a negative indicator for future CPI measures since producer prices tend to filter into consumer prices over time.

In any case, the Fed does not turn on a dime. They would have to see at least one, perhaps two more months of rising inflation before abandoning the unemployment part of the dual mandate and returning to rate hikes to fight inflation. Even if inflation continues, the Fed could decide the unemployment fight is more important and simply let inflation take its own course.

For now, the Fed will cut rates to help the employment situation. But with inflation refusing to die, that preference may change in the near future.

Conclusion: The Markets Lead the Fed

The next Fed meeting is January 28-29, 2025, the first meeting for the new year. The Fed’s policy move at that meeting will be a close call. The Fed may cut interest rates again by 0.25% given the deteriorating employment situation. On the other hand, the Fed may stand pat in view of the increasing inflation metrics.

This decision is truly data dependent and will be made on the basis of new inflation readings (PPI on January 14, 2025, and CPI on January 15, 2025) and the December employment report (January 3, 2025). The January employment report will be released on February 7, 2025, and therefore not in time for the January 29 meeting.

This kind of data dependence is revealing because it shows the Fed is following markets and not leading them. That’s bad news for investors because if the Fed were leading the economy, they would get ahead of the coming recession. They’re not doing either.