The Fed’s Job Just Got a Lot More Complicated

Article originally posted on CoStar on March 15, 2023

Bank Collapses Present New Challenge to Monetary Policy

For a while now, the Federal Reserve’s mantra has been “data dependency” in determining the direction of monetary policy. But what happens when macroeconomic data remains robust, pointing to a continued tightening path, while financial instability emerges, suggesting a more-cautious approach is needed?

That appears to be on the agenda for this week, as the banking system comes under pressure. Financial and equity markets were roiled at the end of last week and into this week as regulators shut down Silicon Valley Bank after depositors fled with their money, leaving the bank in a liquidity crisis.

The contagion spread quickly to Signature Bank, which regulators also seized, and to the collapse of Silvergate Capital, which was liquidated over the weekend. It’s too early to say whether this crisis of confidence will spread to larger institutions — or to other sectors, but business leaders and government officials are doing their best to staunch the bleeding.

In the commercial real estate sector, the recent rise in interest rates has plagued market participants. Higher financing and operating costs are causing investors to pause on trades, trimming valuations and boosting default risk.

Meanwhile, over in the labor market, firms continue to hire at above pre-pandemic levels. In February, 311,000 jobs were added, following a revised 504,000 in January, blowing away expectations and suggesting pretty healthy business conditions. After all, employers hesitate to pad staffing levels when they see a downturn coming.

While the three-month average has been on a broad downward trend lately, it’s still higher than the pre-pandemic three-month average (2015-19). Moreover, the number of people reportedly employed has grown by 1.8 million during the past three months, more than three times higher than that recorded for the same period before the pandemic.

The contrast between panicky financial markets and solid job gains brings the discussion of future rate increases (purportedly needed to cool inflation) to a level of confusion.

Adding to the uncertainty is the fact that, beneath the surface, hiring trends aren’t as rosy as they seem. Accommodation and food services firms led job gains because consumer preferences continue to shift towards travel and dining out and away from purchases of physical goods like furniture and exercise equipment. Hotels, bars and restaurants added 84,000 jobs in February. Yet despite persistent gains for well over a year, staffing levels in this sector are still 346,000 positions below pre-pandemic levels.

Similarly, filling job vacancies in education and health care services, as well as in local governments, has been challenging since the start of the pandemic and these sectors are still trying to make up ground. Because they are anti-cyclical, hiring tends to depend more on population growth than economic conditions, so the observation that they are adding positions may not be as indicative of a healthy economy as hiring in other sectors might be.

And indeed, several industries are downsizing. Among them is the information sector, which fell by 25,000 positions in February. For months, tech firms have announced planned layoffs, but these have yet to significantly impact job figures, so this could be the tip of the spear. Transportation and warehousing firms also shed 21,500 positions, with large losses in both truck transportation and in warehousing, an early indicator of slowing consumer spending. Manufacturing contracted by 4,000 positions, mostly in furniture, food and clothing, also at companies producing consumer goods.

While hiring remains robust, job openings are not falling very quickly. Vacancies remain elevated at 10.8 million as of the last business day in January, having fallen by 410,000 from December. However, a sharp contraction in construction openings illustrates how rapidly vacancies can fall relative to job counts. Openings in the construction industry fell by 240,000 in January, a fall of 49% from the previous month. Accommodation and food services firms withdrew nearly 204,000 job openings, a 12.2% decline.

The Federal Reserve is counting on vacancies to continue to fall without the unemployment rate rising much to achieve its much hoped-for (and largely now dismissed) soft landing.

Even with a strong labor market, wages are not keeping up with inflation. The latest consumer price index reading showed prices rising by 0.4% in February over the prior month, faster than the hourly wage growth of 0.2%.

Part of the slowdown in wage growth is likely due to the composition of job growth, as the sectors seeing the strongest hiring recently are generally among the lowest-paid sectors. In contrast, higher-paid industries saw job losses, including information and financial activities.

What We’re Watching …

While the monthly gain in prices slowed in February, inflation remains uncomfortably high.

The year-over-year gain was 6.0% (not seasonally adjusted), slower than the January 12-month increase of 6.4%. This is encouraging news for the Federal Reserve, as it considers its next policy move, expected a week from now.

After the release of the February jobs report last Friday (before news of the banking collapse), it was widely assumed that the committee would consider a larger increase of 50 basis points, given the robust hiring in February, and nominal wage growth that remains faster than would be consistent with its 2% inflation target. That has all changed, now, of course, with many on Wall Street expecting a smaller 25 basis-point increase, although with the risk of further financial instability, some are expecting the Fed to stand pat.