MainStreet Macro: Hold ‘em, fold ‘em, or walk away?

Some songs capture the ethos of the moment. As Federal Reserve policymakers ponder how to play their hand on interest rates this week, Kenny Rogers has some advice: You gotta know when to hold ‘em, know when to fold ‘em, know when to walk away, and know when to run.

With Kenny’s wisdom in mind, here’s a look at the Fed’s cards and what policymakers might be thinking.

Hold ‘em

The Fed raised rates 10 consecutive times before taking a break last month, and it could stick to that strategy again when policymakers meet this week. In less than a year, the benchmark federal funds rate has climbed from near zero to more than 5 percent. Mortgages, small business loans, and credit card rates have climbed, too.

If the Fed resumes tightening, rates will be at their highest level in more than two decades.

One reason to stay the course with rate increases is that labor market conditions are still tight. The unemployment rate fell to 3.6% in June, near historic lows.

Layoffs, too, are near historic lows. Weekly initial jobless claims, an indicator of layoffs, averaged 246,750 in the four weeks ending July 8, up from 215,000 in the same period a year earlier but still in line with pre-pandemic levels.

How long will the labor market stay strong? The risk of holding the line on rate increases is that unemployment starts to increase. Companies under pressure from the rising cost of financing might start shedding workers.

It’s a risk that could lead the Fed to …

Fold ‘em

The best players quit while they’re ahead, and there’s a good reason to extend last month’s pause: lower inflation.

In June, inflation fell to 3 percent, its smallest 12-month increase since March 2021. When you subtract volatile food and energy costs, inflation rose less than 0.2 percent in June from May, the smallest monthly increase since August 2021.

Inflation in services, less energy, is still strong, up nearly 6.2 percent. However, there are signs of relief here as well. Wages, a big driver of costs for the service industry, have been steadily cooling for the past three months.

People who have been with the same employer saw a median, year-over-year wage increase of 6.4 percent in June, down from 6.6 percent in May according to ADP Pay Insights data, which measures 10 million matched individuals tracked over a 12-month period.

For job changers – people in a job for less than 12 months – pay gains have slowed for 12 straight months, falling to 11.2 percent in June, the slowest pace of growth since October 2021.

But wages are still elevated, and housing costs continue to rise. If the Fed folds too soon, it could risk another inflationary bump.

Walk away

Even though inflation remains higher than the Fed’s 2 percent target, the central bank might decide to walk away from its tight monetary policy if the economy starts to falter.

The economy dealt the Fed a better-than-expected hand in the first three months of the year.  Real GDP grew at an annual rate of 2 percent in the first quarter, up from a previous estimate of 1.3 percent. The upward revision reflected stronger-than-expected consumer spending and exports.

Incoming retail, job, and corporate data suggest a positive but slowing outlook for the second quarter of the year. Moving forward though, economist estimates for the second half of 2023 are split between a mild recession and a soft landing.

For now, it looks like the U.S. could narrowly skirt a recession in 2023. But if growth is no longer in the cards, the Fed could decide to walk back rate hikes to stimulate the economy.

My Take

This isn’t a poker game, and the Fed can’t run away from its dual mandate of price stability and full employment.

However, there are times when the central bank’s two driving policy goals conflict. Higher interest rates meant to curb inflation have at times, weakened the job market and triggered recession.

Fortunately, the economy continues to deliver despite sharply rising borrowing costs. For now, the Fed seems to be playing a winning hand in containing inflation and maintaining economic growth.