The Trouble With Projecting Fed Policy From September’s Jobs Data

After a strong start, stocks retreated to close the week, with the S&P 500 down -2.4% as we type early Friday morning.^[i] The culprit for the day’s selloff, according to most accounts, was September’s US employment situation report, which showed an unexpected dip in the unemployment rate and nonfarm payrolls rising by 263,000.^[ii] A few outlets noted that the pace of hiring has continued to slow—from 315,000 in August and 537,000 in July, and an average of 493,000 in the 12 months prior to Friday’s report. Yet given jobs growth remains quick, most outlets quickly dismissed that: Yeah but the Fed still needs to do more was the common theme, implying we will eventually get to a point where the Fed must kneecap the economy in order to tame the inflation beast, lest it risk allowing a hot job market to fuel a wage-price spiral. We don’t buy this thesis, and we think investors would do well to understand why.

Conventional wisdom—and the Fed’s dual mandate of seeking maximum employment with stable, low inflation—hold that the job market drives wage growth, which drives inflation. Ergo, the Fed should raise interest rates to cool hiring in an inflationary environment like the present and cut them to spur hiring when unemployment is up. Nobel laureate Milton Friedman shattered this myth decades ago, and simple logic does the same today. He showed inflation drives wage growth, not the other way around. Think about it from a worker’s perspective: When are you most apt to hound the boss for a raise? When your rent hasn’t gone up for years, food prices are stable and gas is reasonable? Or when you are suddenly faced with a 10% premium to renew your lease, a newly astronomical grocery bill and much higher fuel prices? Employers understand this too and factor recent inflation into their wage and salary offers. If it were the other way around—if companies randomly raised wages, then prices, then wages, then prices—then inflation would be a merry-go-round that never stops and would start for basically no reason. Money supply growth, supply chain issues and all of the things that have actually driven inflation this year wouldn’t matter.

Secondly, there just isn’t much the Fed can do right now, in a practical sense, to affect hiring noticeably. Traditionally, it would try to control money supply growth by using its benchmark interest rate to influence the yield curve—Fed controlling the short end, market controlling the long end. The gap between the two (long rates minus short) would influence banks’ net interest margins on new loans, as banks generally borrow at short rates and lend at long rates. Banks aren’t charities, so the potential profit margins would influence their willingness to lend at borrowers’ varying degrees of creditworthiness. For good measure, the Fed would also raise or lower reserve requirements to give banks a shorter or longer leash. In a fractional reserve banking system like ours, banks create a large share of new money through lending, so enabling more lending would boost the money supply, which in turn would driver faster growth and more hiring. Disabling lending would slow money supply growth, cooling the economy and tamping down job growth. The relationship between the quantity of money and the amount of goods and services available for it to chase would determine inflation.

That last bit still holds, in our view. But the Fed has surrendered most of the control over money supply it had in the past. American banks hold nearly $18 trillion in deposits and have nearly $11.7 trillion in outstanding loans.^[iii] Fed head Jerome Powell and the Federal Open Market Committee also decided to scrap all reserve requirements in 2020, so with such a wide gap between deposits and loans, banks could lend hand over fist if they wanted to—regardless of recent Fed hikes. Yes, the Fed may presently set its benchmark overnight rate at 3.0 – 3.25%, but that rate chiefly affects the rate at which banks borrow from one another to meet overnight liquidity requirements. Because of that astronomical deposit surplus, banks aren’t paying the fed-funds rate to get money to lend out. Their deposit base seems like more than enough funding, and that base costs an average 0.17%.^[iv] So as long rates rise, lending gets more profitable—and lending has accelerated this year.

So whatever is happening in the job market likely has pretty little to do with the Fed. Now, if you read this and conclude the Fed’s efforts to fight inflation must be hopeless, well, we agree in principle. But would prefer “feckless” to “hopeless,” because the good news is that inflation appears likely to cool regardless. Lower commodity prices are starting to feed into the economy, transit costs are down and shipping times are shortening. Businesses are finally able to fill order backlogs, which should increase the supply of goods available for sale. Broad money supply growth is back at pre-pandemic rates. All of the weirdness of the past two and a half years is getting further into the rearview mirror.

Of course, despite all the speculation running rampant in the punditry, no one knows what September’s jobs data mean for future Fed hikes. The Reserve Bank of Australia’s smaller-than-forecast 0.25 percentage point hike on Monday just finished proving, once again, that central banks will do what central banks will do based on their view of incoming data, and analysts won’t know which data they emphasize and which they don’t—much less how the cabal of policymakers will interpret those data.^[v] Maybe Powell & Friends see the slower average pace of hiring and August’s 10% drop in job openings as a forward indicator that their policy is working, September’s hiring numbers be damned.^[vi] No one knows. Hence, to us, Friday’s move seems much less about the actuality of what the Fed may do and much more about sentiment.

The notion of a heavy-handed Fed crippling an inflation-ridden economy has weighed heavily this year. But, in time, as inflation gradually begins to resolve on its own, the reality of a feckless Fed that lacks the power to materially sway the economy for good or ill should bring palpable relief. It isn’t exciting or some immediate catalyst, but rather, the sort of thing that is a subconscious, non-realization that markets see even if humans don’t outright acknowledge it. Think of it as a general sense of huh looks we got through all that after all.

Equally important, this all holds even if the US officially enters a recession, as stocks look 3 – 30 months out. The S&P 500’s bear market this year would be consistent with stocks pre-pricing a recession, giving the actual declaration of one precious little power over stocks at this point. So we think investors are better off looking forward, as markets do, to the likely better times ahead.