Beige Book: More Inflation, More Rate Hikes

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Beige Book: More Inflation, More Rate Hikes

The market continues to discount ever more aggressive US monetary policy and today was no different after the release of the Fed’s latest Beige Book, which showed elevated inflation becoming further entrenched. We’ve reviewed this report the day it comes out two weeks before each Fed meeting for over half a decade because it provides a lens into the business conditions that Fed policymakers’ contacts share with them. Fed Chair Powell has also been a vocal proponent of the report and we’ve seen it influence his views on monetary policy.

Here is an update on hot button issues we track by tallying how many mentions they receive in each Beige Book edition:

Virus-related terms: 26 mentions of the virus in the latest report compared to 29 in last month’s edition, 31 in January and 16 in early December 2021.

Inflation: 26 mentions, up from 15 in March, 8 in January and 6 in December.

Supply disruptions/supply chain disruptions: 17 mentions, up from 15 in March and January, but down from 25 in early December 2021.

Labor shortage/s: 19 mentions, versus 17 in March, 16 in January and 25-26 in September through December.

Takeaway: the word count for inflation almost doubled from the last report, putting further pressure on the Fed to get it under control. On the positive side, there were fewer mentions of supply chain disruptions and labor shortages compared to Q4 2021, showing businesses are learning to adapt to these challenges while maximizing their pricing power. Even still, references to these issues picked up from last month and both help inflation imbed itself into an economy, exactly what the Fed is trying to avoid.

Now, let’s move on to our key takeaways from the Fed’s regional contacts’ “on-the-ground” color:

#1: US economic activity “expanded at a moderate pace since mid-February”, an upgrade from just a “modest to moderate pace” from the last report at the beginning of March.

  • Consumer spending “accelerated” across both retail and non-financial service firms as the virus outlook improved.
  • The Fed’s business contacts described manufacturing activity as “solid overall”, but firms still struggled to meet demand amid “supply chain backlogs, labor market tightness, and elevated input costs”. Similarly, low inventory continued to constrain both vehicle and residential real estate sales even with continued strong demand.
  • A pickup in office occupancy and retail activity helped commercial real estate to “accelerate modestly”.
  • Farmers were helped by “surging crop prices”, but “increasing input costs were squeezing producer margins across the nation.”

Looking ahead, “outlooks for future growth were clouded by the uncertainty created by recent geopolitical developments and rising prices.” That’s a gloomier take than the outlook last month, which was characterized as “generally optimistic” even with an “elevated degree of uncertainty”.

#2: Employment grew moderately, as demand for workers remained strong but hiring was still constrained by the dearth of available workers.

  • On the plus side, “several districts reported signs of modest improvement in worker availability”, better than just seeing “scattered signs” like in the last report. That said, employers continued to grapple with “significant turnover” as workers leave for both “higher wages and more flexible job schedules”.
  • Wages continue to grow strongly amid “persistent labor demand” and “particularly for foot-loose workers willing to change jobs”. For what it’s worth, the Fed’s own data backs up this observation. The Atlanta Fed’s Wage Growth Tracker shows the 12-month moving average of median wage growth based on hourly data was up 5.3 pct for job switchers versus just 4.0 pct for job stayers as of last month.
  • The Fed’s business contacts said “inflationary pressures” were “contributing to higher wages, and that higher wages were doing little to alleviate widespread job vacancies”.

#3: Inflationary pressures “remained strong” as firms continue to “pass swiftly rising input costs through to consumers” amid robust demand. One example includes fuel surcharges for freight and airline fares. At the same time, “contacts in a few districts noted negative sales impacts from rising prices”. That’s in contrast to the last report, which noted an “increased ability to pass on prices to consumers”.

More broadly, there were steep increases – especially in manufacturing – in raw materials, transportation, and labor costs. Additionally, the Russia-Ukraine crisis “spiked” energy, metals, and agricultural commodity prices, while virus shutdowns in China exacerbated supply chain disruptions. Consequently, “a few reports noted that input suppliers were making use of more flexible contract terms or only honoring price quotes for 24 hours.” Looking ahead, “firms in most districts expected inflationary pressures to continue over the coming months”.

Takeaway: inflationary pressures continue to build, so much so that some firms are leveraging their pricing power to dynamically change how much they charge over very short timeframes. That’s certainly not consistent with the Fed’s price stability mandate. Additionally, rising prices are putting upward pressure on wages, feeding a vicious inflationary cycle. As a result, Fed Funds Futures are pricing in a more aggressive Fed at upcoming meetings by the day:

  • The probability of a 50 basis point hike at the May 4th meeting is 93 pct; there’s just 7 pct odds for a 25 bp increase.
  • The Fed Funds contract for the June 15th meeting now gives the largest odds to a 75 bp hike at 49 pct, up from 37 pct just yesterday. Odds for a 50 bp bump stand at 48 pct, down from 58 pct a day ago.
  • By the end of 2022, Futures are now putting the highest probability of Fed Funds at either 2.50 – 2.75 percent (38 pct odds, down from 42 pct just yesterday) or 2.75 – 3.00 percent (39 pct odds, up from 34 pct a day ago). The latter and higher outcome continues to gain momentum, as the odds a week ago were only 14 pct. Additionally, Fed Funds at 3.00 – 3.25 pct now have odds of 11 pct, up from only 1 pct a week ago.

Bottom line: we continue to advise caution on US equities until markets get a better handle on the most likely path of monetary policy this year. The next Fed meeting just two weeks from today should provide more clarity.