This new academic paper finds that about 7% of US adults, or around 19 million people, still suffer from long covid. And of those with long covid, 25%, or about 5 million people, report that their day-to-day activities are impacted ‘a lot’.

The bottom line is that long covid is why the labor force participation rate has not recovered to pre-pandemic levels, even in a situation with solid wage growth, see chart below. In other words, people are staying outside the labor market for health reasons and are unlikely to come back in the near term.

These “missing” workers are why companies continue to report labor shortages and why wage inflation remains so high. This continues to be a challenge for the Fed as the FOMC tries to get inflation quickly back to the Fed’s 2% inflation target. Immigration is starting to increase, but ultimately long covid is a key reason why the Fed will have to keep the Fed funds rate elevated for an extended period.

Our latest housing outlook is available here, key charts inserted below.

The Fed just released new data for the amount of money households have in their checking accounts and short-term deposits, and it shows that households across the income distribution continue to have a higher level of cash available than before the pandemic, and the speed with which households are running down their cash balances in recent quarters has been very slow. Combined with continued solid job growth and robust wage inflation, the bottom line is that there remains a powerful tailwind in place for US consumer spending.

I will be on Bloomberg TV today at 7:30 am to preview the December CPI data, and the key question for the Fed and markets is if a recession is needed to get inflation all the way back to the FOMC’s 2% inflation target. Economic models, such as the Phillips curve, would say that a much higher unemployment rate is needed to get inflation down to 2%. But maybe economists are too wedded to their models? What if inflation is mainly driven by supply shocks that are going to sort themselves out over time without any need for additional demand destruction (as suggested by Fed papers here, here, and here).

So far, inflation has been trending lower without any increase in the unemployment rate, suggesting that we are in the soft landing scenario. A continued solid economy with falling inflation and steady corporate earnings is good news for both IG and HY credit. But with inflation at 7.1%, the Fed will continue to be hawkish, and as a result, markets will likely remain volatile as we go through 2023.

Download our latest credit market outlook here.

Inflation data will come out tomorrow and the consensus expects a decline in inflation from 7.1% in November to 6.5% in December.

With inflation trending lower since June, the Fed is moving from 75 to 50 to 25 basis point hikes, and the market is interpreting the downshift in rate hikes as dovish because there is now more clarity about what the peak will be in the Fed funds rate during this cycle.

But the market’s focus on the change in inflation rather than the level of inflation is a problem for the Fed. The Fed worries about the level of inflation being too high and wants to be hawkish to make sure that inflation gets all the way back to 2%.

In other words, the market takes its cue from the change in the inflation rate, and concludes that “inflation is coming down, so everything is fine and we can trade stocks higher and credit spreads tighter.” But this is a problem for the Fed because the Fed is worried that easier financial conditions will delay further the move in inflation back to 2%, see chart below.

The bottom line is that the endogenous nature of the loop in the chart below leaves the Fed with no other options than to continue to be hawkish, and this continued hawkishness is limiting how much equity and credit markets can rally over the coming months.

There is a market narrative that European governments are spending more on defense spending and the ECB is doing QT, and this will push yields higher on European government bonds. 

The problem with this story is that US long rates are going down because the Fed will soon pause, and European inflation is going down, see chart below. Combined with European inflation being mainly energy, where the 12-month change will roll over in March 2023, the net effect is that US rates going down and inflation in the US and Europe going down will likely dominate the idiosyncratic stories in Europe. 

As a result, global government bond yields will likely decline, including in Europe. The fundamental reason is that inflation will be less and less of a problem as we go through 2023, and the move lower in global rates will be particularly significant if we get a recession in the US.

The Fed has calculated what forward guidance and their balance sheet policy mean for the Fed funds rate, and their estimates show that the proxy Fed funds rate, which also includes forward guidance and the Fed balance sheet, is significantly higher. Specifically, these Fed estimates show that monetary policy is much tighter with the proxy Fed funds rate at 6% rather than the official 4%. The bottom line for markets is that the true stance of monetary policy is tighter at 6% than the Fed funds rate at 4%, see chart below and here. In other words, comparisons with history and discussions of how restrictive monetary policy should not only look at the level of the Fed funds rate but also include the new tools that the FOMC is using today to cool the economy down.

Wage inflation is rolling over across the income distribution, see chart below. A slowdown in wage inflation is exactly what the Fed is trying to achieve with tighter monetary policy. And note how it is happening without an increase in the unemployment rate. Lower inflation with a steady economy and steady earnings is the definition of a soft landing.

Fed: How sensitive is the economy to large interest rate increases? Evidence from the taper tantrum

https://www.federalreserve.gov/econres/feds/files/2022085pap.pdf

The Myth of Central Bank Independence

http://d.repec.org/n?u=RePEc:ajw:wpaper:06813&r=mon

The Effect of Pension Wealth on Employment

https://docs.iza.org/dp15836.pdf