Since the lows of last October (2022), financial markets have rebounded higher in-line with the post COIVD re-opening of the Chinese economy and a simultaneous mild winter in Europe. At home, we have also experienced an exceptionally resilient labor market in the face of tightening monetary policy and subsequently credit conditions. Measures of inflation in the US economy are trending lower from their post-COVID peaks of around 10%, which is great news, but being above 4% is still nowhere near the Fed's target of 2% so its safe to expect more policy tightening from the central bank. The market reaction to more of the same from the Fed might be a little different going forward as expectations fall in-line with the economic reality the world faces. As inflation has been falling in the US over the past couple of fiscal quarters, so has the dollar as market participants anticipated an eventual pivot in monetary policy back towards accommodation and easy money.
The coming couple of fiscal quarters will probably see the impacts of rising interest rates finally hit the labor market in a meaningful way. Thus far the recent memories of labor shortages during the post-COVID re-opening in the US, means employers are more likely to cut hours versus cutting headcount. The apparent labor hoarding has been supporting wages, which paired with falling inflation means consumers have been experiencing real increases in their income, albeit from depressed levels. Stocks markets have latched-on to this idea and are reflecting a world where economic activity slows just enough to bring inflation down, but not enough that lots of people lose their job as a result of the slowdown. Classic case of wishful thinking.
The labor market tends to be a lagging indicator of economic activity, and so by the time businesses en-masse decide that its not worth holding onto a full staff and labor supply overshoots labor demand, interest rates would have been too high for too long and the damage would have already been done. As the summer months approach, market participants will have to adjust their expectations for economic activity in the back half of the year. Consider two scenarios: 1) The rate of change of the drop in inflation slows and the Fed keeps ratcheting up interest rates until economic activity grinds to a halt, and we get an acceleration in unemployment and inflation finally drops back down to the Fed target with a recession. 2) The long and variable lag in monetary policy is realized and market participants conclude the Fed has already gone too far as the rate of change of the drop in inflation accelerates taking it below the Fed target and creating an event sharper jump in unemployment, resulting in a recession. We are dealing with an issue of what flavor of recession will (not can) the Fed create. The difference being short and deep where there is a sudden drop in inflation and economic activity which the Fed can quickly address with interest rate cuts. Versus long and shallow where there is a grind lower in economic activity and inflation, to which the Fed's response will be hesitation to accommodate as they will fear a resurgence of inflation which would put them in the opposite of liquidity trap, where addressing one problem exacerbates another. In either scenario, the US consumer goes on the defensive and corporate earnings are directly affected negatively.