Is the Federal Reserve Falling Behind in Price Stabilization?

Unusual Economic Behavior

Concerns are growing that the Federal Reserve (Fed) is falling behind in its efforts to stabilize prices. The strong US jobs report last Friday has dispelled fears of an immediate recession but has heightened concerns that the Fed's aggressive easing cycle could reignite inflation.

Both the Joshi rule and Sahm rule recession indicators have unexpectedly retreated from their event horizons. This is unusual because crossing the event horizon usually indicates an increase in unemployment. However, instead of increasing, US unemployment is stabilizing.

The Joshi rule and Sahm rule event horizons are the points at which higher unemployment usually triggers a negative feedback loop. Weak growth is noticed, leading people to cut back on spending, which further weakens sales and profits, pushing the economy into recession.

What makes the US economy unique at the moment is its 'inverted' state. This means that output is being driven by supply rather than demand. This highly unusual behavior of the US economy is due to its highly unusual, 'inverted' configuration.

Aggressive Fed Rate Cuts and Inflation

The Fed's 2 percent price inflation target requires wage inflation to be at 2 percent plus the assumed growth in productivity. Considering the pre-pandemic average productivity growth of around 1 percent, this means that wage inflation must decrease to around 3 percent (from its current 4.1 percent).

Wage inflation could settle at more than 3 percent if post-pandemic productivity growth has increased significantly. However, the Fed acknowledges that basing policy on this assumption would be risky.

The job vacancy rate is the best leading indicator for wage inflation, according to the Fed. A 3 percent wage inflation target requires the job vacancy rate to settle at 4.25 percent. However, over the last five months, the job vacancy rate has been settling at around 4.75 percent, a rate it never exceeded during the pre-pandemic years.

The difference between the job vacancy rate stabilizing at 4.25 or 4.75 percent may seem insignificant, but it is not. This difference could mean the difference between price inflation stabilizing at 2 percent or at 2.5 percent.

Profits Recession vs. Valuation Recession

Without a recession, the real risk is not a profits recession, but a valuation recession. As predicted four weeks ago, short-dated US interest rate futures and 2-year T-notes were overpriced for rate cuts, making them compelling underweights. Following the strong jobs report, the recommended short position in the Feb 2025 Fed funds future contract is comfortably in profit.

However, without a recession, the pricing for Fed easing is still too aggressive. The Fed is still priced for almost 100 basis points of rate cuts from now through March, whereas the Bank of England is priced for just 50 basis points. Yet the reality is likely to be a much smaller difference, one way or the other.

Gold as a Counterintuitive Short

Finally, a counterintuitive recommendation on gold. On the surface, a Fed that is behind the curve to stabilize prices should be good for the inflation hedge, gold. Yet if the Fed reacts by cutting rates much less than is priced, as strongly believed, then it will boost the dollar, which is bad for gold.

Moreover, the near-50 percent rally in gold over the past year has taken its 260-day price complexity to the point of collapse that has reliably marked previous rally exhaustions. Given gold’s spectacular rally has reached this point of fragility, combined with expected dollar strength, gold is being downgraded to underweight on a cyclical horizon.

Bottom Line

It appears that the Federal Reserve may be falling behind in its efforts to stabilize prices, with concerns that aggressive rate cuts could reignite inflation. The unusual behavior of the US economy, driven by supply rather than demand, is also a factor to consider. The real risk may not be a profits recession, but a valuation recession. And while gold may seem like a good hedge against inflation, the expected strength of the dollar could make it a risky investment. What are your thoughts on these economic indicators and predictions? Share this article with your friends and discuss. Don't forget to sign up for the Daily Briefing, every day at 6pm.