Perspective: Morning Commentary for August 27

August 27 – There’s a bit of a malaise on Wall Street this morning, as the major stock indices trade just below record levels ahead of a three-day holiday weekend, amid uncertainty in the Middle East, and ahead of the next big monthly jobs report. Jobs are now the primary focus following last week’s statements from the Federal Reserve. The VIX is trading near 16 this morning, while the dollar index is trading near 100.9. Yields on 10-year Treasuries are trading near 3.86% this morning, while yields on 2-year Treasuries are trading near 3.95%. Crude oil prices are pulling back modestly, while the grain and oilseed markets were mixed to weaker as well. Corn and wheat prices are trading at or near new multi-year lows, while soybeans are modestly above that, on recent fresh demand, despite facing perhaps the more bearish supply and demand fundamentals of the three major crops. Corn and soybean crop ratings turned lower in the last week as a brief heat wave hit the Midwest over the weekend to stress crops. But an increased chance of showers is expected to usher the heat out in the days ahead.

“He (Powell) went on to say that it is unlikely that the labor market will be a source of further inflationary pressures, and that the central bank does not seek or welcome further cooling of the labor markets. Translate that to mean that Powell and the rest of the Federal Open Market Committee have shifted their focus from fighting inflation toward stimulating the jobs market.” The above quote came directly from my Midday Commentary on Friday following Federal Reserve Chair Jerome Powell’s address to the Jackson Hole Economic Symposium. Powell spoke of this shift twice during his speech, and other members of the Federal Open Market Committee have made similar statements since Friday, reflecting the significance of this change in emphasis. The significance of this change in emphasis should not be taken lightly.

The unemployment rate is currently at 4.3%. Comments made by Powell and other FOMC members since Friday suggest that a number north of 4.5% is considered unacceptable. Most of us who have a few grey hairs on our head tend to think of unemployment in the 4.5 – 5.0% range as being relatively normal. The FOMC apparently has defined normal as a number less than 4.5%. Why is that important? We have a jobs report coming out again in about 10 days. That report will likely dictate to a great extent whether we see a 25-basis-point rate cut on September 18, or a 50-basis-point rate cut. The expectation is that it will be a 25-basis point rate cut, but a “poor” jobs report which is largely being defined as something of 4.5% unemployment or higher could see that elevated to 50 basis points. Members of the FOMC believe that we need to see the rates move down to their “natural” levels now that inflation is “under control.” They see natural rates being at 2.5% or lower, although that debate is still very much alive. I believe that the natural rate is higher in this day of elevated fiscal stimulus, but it’s not my opinion that matters to monetary policy. As such, they want to see rates get down to “natural” levels over the next year to year-and-a-half. The speed at which they intend to do so should show up in the next dot plot graphic to be released after the September Fed meeting. I agree that inflation is likely going lower near-term. But taking rates down to 2.5% or lower at a time when fiscal stimulus remains elevated can put us right back into an inflation scenario.

The Fed is spooked about the unemployment rate rising to 4.3%, resulting in a significant shift in policy focus. But we lack evidence that the rise to a still low 4.3% is due to recessionary pressures. Challenger job-cut data indicates that layoffs are at their lowest level of this century currently. Part of the reason for the jump in the unemployment rate is the rise in the pool of workers, rather than a reduction in jobs. More people are getting back into the job market, raising the job participation rate, while the pool of workers is also growing due to a record fast pace at which applications for citizenship are being processed in recent months. So is this the time to dramatically cut interest rates?

What is the purpose of a rate hike? It is to slow down consumer buying to reduce demand, bringing in into balance with supply, to reduce inflationary pressures. A rate cut has the opposite impact. It is designed to stimulate consumer buying, increasing demand, which therefore increases orders for factories to make more, increasing employment and the battle for workers. Our nation’s monetary base has been trending higher over the past year-and-a-half as fiscal spending pumps money into our economy, despite the Fed’s best efforts at withdrawing stimulus from the economy via quantitative tightening. That means that the money is still there for spending once that confidence in the economy returns. The primary question is one of timing? The consumer has been told that 200 basis points of rate cuts are coming over the next year, so will the consumer spend now, or wait for lower rates to do so? That will have a big impact on the shorter-term path of our economy. But lower rates will stimulate, and inflation will return. It’s just a matter of messaging to the consumer, and the timing of the consumer’s response.