Other economic signs point to a recession and higher interest rates

The Federal Reserve’s heavily telegraphed decision to ease its pace of monetary policy tightening next week risks sending a message to markets that the central bank is on track to bring inflation under control and steer the economy toward a soft landing. Investors would do well to reevaluate.

Regardless of the Fed’s pace of monetary policy tightening, the most consequential message the economy is sending now is that the central bank will likely need to raise interest rates beyond the roughly 5% range expected by the markets in order to combat the current crisis. inflation approaching its target level. And that, in turn, suggests that at least a mild recession seems increasingly necessary for prices to finally cool.

“We are heading for a hard landing. And that’s a tough story to sell because the data looks good,” says Aneta Markowska, chief financial economist at Jefferies. “That will change.”

The optimist camp argues that the combination of The gentle chill of October in the consumer price index, the subtle drop in labor demand, and the Fed’s own downgrade suggests the economy is softening in all the right ways, responding to tougher policy without falling off a cliff. But what this argument overlooks is how much inflation and the labor market still need to fall – and how painful that fall will be.

Consider first the continued strength of the country’s service sector. New information released last week showed growth in the services sector unexpectedly accelerating in November as resilient consumers continued to spend. This has pushed services activity to a level that, as Citi economists put it, “raises again the prospects for a higher rate regime for longer,” given that services inflation shouldn’t be slowing down anytime soon.

The Producer Price Index, released on Friday morning, was also warmer than expected and showed services prices accelerating even as goods prices slowed.

With the service sector booming, the share of workers leaving jobs, which had been falling, is now stabilizing in two key service industries that had driven much of the great quitting, according to a analysis of government data by Nick Bunkerdirector of economic research at the Indeed Hiring Lab.

Bunker found that the so-called quit rate in the retail sector has leveled off, while in leisure and hospitality the rate has started to rise again. This is important because economic research has shown that an increased proportion of workers leaving their jobs can put upward pressure on wages as employers compete to hire and retain employees.

And wages have indeed started to warm up. The average hourly wage climbed 0.6% last month and has accelerated in each of the past three months, dashing budding hopes of a slowdown in earnings.

While some analysts had brushed off concerns about rising wages – suggesting that much of November’s increase was due to a less concerning drop in hours, rather than an increase in wages – a separate measure released on Thursday pointed out that incomes continue to climb: The Atlanta Fed’s wage growth tracker showed wages accelerating last month to an annual growth rate of 6.2% in November, from 6% the preceding month.

The different ways of measuring income today “all tell a consistent story,” says Jason Furman, an economist at Harvard University. “No moderation in wage growth.”

For the Fed, runaway wage growth is worrisome because it is fueling inflation in the services sector, where prices continue to soar, even as other sectors are beginning to see some relief. This forces the central bank to hold higher rates for longer in an attempt to depress demand.

But there is a second consequence that could be just as destabilizing. The higher wages rise, the more they will squeeze profit margins for small businesses that fuel the labor market and are responsible for the vast majority of current job openings, says Markowska. She points out that the share of small business owners raising wages is rising at the same time that the share raising prices is collapsing, according to a recent survey by the National Federation of Independent Businesses. “That margin space that was created by the power of pricing and the fact that wages were lagging – it’s about to reverse,” she says.

Markowska sees small business profits under pressure in the first quarter of next year, especially as companies make cost-of-living adjustments in January that could push up wages. That, in turn, can cause companies to withdraw job offers and lead to a cycle of layoffs, she says. And suddenly the labor market stumbles, even as inflation remains well above target.

Seen in this light, rising wages can quickly undermine the two most crucial elements for staging a soft landing: falling inflation and a stable labor market. The Fed needs both, and soaring worker wages could mean the central bank is no closer to getting either.

All of this suggests that a hard landing and recession are more likely than markets are expecting. And the longer equity investors remain optimistic, the more damaging the fallout could be. “That’s another mechanism by which a potential recession could get worse as it penetrates the markets,” said Larry Summers, the former Treasury secretary. Barrons.

Summers warns that with an almost inevitable economic slowdown, in his view, there is a “significant risk” that the Fed will cut interest rates before inflation even returns to its 2% target. While this may help the economy in the short term, it could also backfire by requiring a second, possibly more damaging round of rate hikes soon after.

The result could resemble the experience of former Fed Chairman Paul Volcker in the early 1980s, when the central bank began cutting rates in response to the recession only to drive them up even higher when the inflation began to stabilize.

“We’re all taught that when the doctor prescribes us antibiotics, we’re supposed to take the whole course,” Summers says. “But very often people only partially take the antibiotic treatment until they feel better or experience side effects, and then they have to take the medicine again.”

Write to Megan Cassella at megan.cassella@dowjones.com

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