Essential Economics

— Mark Frears

If, then

In our daily lives, we observe lots of linked events. For instance, if you are attending a hockey game for your favorite team, and they score a goal, most likely you will stand up and cheer. Another example is when we go out to eat on Saturday night. But we also go out to eat other nights, so this is not directly linked.

The first example is of causation, where one action is a direct result of the first event. They score, and I stand up and cheer. The second example is of correlation. While we may go out to eat on Saturday nights, it is not because it is Saturday that we go out to eat. They are related, but not one solely because of the other.

There is a lot of work done on correlation in markets, between economic events, seasonality, and different instruments. The real work though, is determining if there is a causal relationship between the two.

Federal Open Market Committee (FOMC)

One of the most closely watched, potentially causal events is the rate moves made by the FOMC on the Fed Funds (FF) target rate. Their dual mandate is to reduce high prices associated with inflation by raising the FF rate, thereby slowing the economy, and to keep unemployment low by lowering the FF rate, stimulating the economy.

Up until last month, they were keeping this rate high, due to high prices, reflected in a multitude of inflation metrics. As prices have come down from their peak, but are not yet at the 2% stated target, they lowered this rate by 0.50% (50 basis points). The thought here is that prices will continue to come down, and perhaps the economy needs stimulus to keep the unemployment rate low. Recent releases have shown the economy is not pushing toward a recession, and prices remain stagnated at above target levels.

What do they do next? Stay tuned two days after the election on November 5. It will be very difficult for them to get a consensus view of the economic future, I believe.

Causation?

There has always been a bit of head scratching about how the FOMC can influence long-term rates by changing an overnight rate. Inflation impact is seen in longer-term bonds. In addition to their FF moves, they also spend quite a bit of time “messaging” their intentions through speaking engagements. This also has an impact on market expectations for their next moves.

A recent paper from Ned Davis Research (NDR) is titled “"Does Monetary Policy Work?”. Pretty bold question. Their premise is that changes in the FF rate (monetary policy) is only loosely related to inflation. As the chart below shows, there doesn’t appear to be a direct link between changes in the real FF rate and subsequent inflation.

Source: Ned Davis Research

A correlation coefficient of only 26% not only shows limited correlation, but you would be hard- pressed to make a case for a causal relationship.

Labor markets

The authors did make the case to show the changes in FF rates were more closely correlated to private sector employment. The main takeaway from this relationship is the impact of wages. The chart below shows the relationship between wage growth and labor market tightness.

Source: Ned Davis Research

If you follow the path one more step, wage growth is closely linked to core inflation, as seen below.

Source: Ned Davis Research

Their conclusion is that monetary policy does impact wage growth, but this is only one part of inflation.

Takeaway

The FOMC’s premise is that they slow economic growth by raising short-term borrowing costs. That will in turn cause prices to stop rising, as demand slows. The problem this time is that demand is not slowing for a majority of consumers, and consequently prices are not coming down as fast as they would like. As you can see below, the cumulative impact of prices is still having a large impact, but the middle- and upper- income households have the means to continue to spend.

Source: Bianco Research

The FOMC will have to slow down the anticipated rate cuts, or they will be back-pedaling with rate increases by next year. That is, if their moves have a causal effect.

Economic releases 

Last week, we had miscellaneous economic releases, showing the economy is still ticking along. Housing will be a drag, but that is supply- driven.

This week’s calendar’s is all about labor. We have JOLTS, ADP, and non-farm varieties. In addition, we have the FOMC’s favorite inflation metric, PCE. See below for more details.