Editor's note: Jimmy Zhu is chief strategist at Fullerton Research. The article reflects the author's opinion, and not necessarily the views of CGTN.
Aggressive tightening by the U.S. Federal Reserve (Fed) since the start of the year has not yet slowed the labor market, as September's employment data showed. The data dashed any hopes that the Fed would slow its pace of rate hikes, even as the risk of recession lingered.
Data released on Friday showed the economy added 263,000 jobs in September, still well above the average reading of around 150,000 per month over the past 10 years, suggesting the current Fed hike cycle has had limited visible impact on the U.S. economy. More importantly, the unemployment rate fell to 3.5 percent in September.
Unemployment in September was at its lowest level since early 2020, when the pandemic began, reflecting a tight labor market in which wage growth, one of the key drivers of inflation, is difficult to slow. Since January, wage growth in the U.S. has remained above 5 percent.
In a tight labor market, workers can generally bargain for higher salaries. Given rising inflation, many workers will likely demand pay increases to match rising prices. Because of the tight labor market, many business owners may agree to what their employees ask for.
Many companies have had to pass on rising labor costs to their clients or consumers. Therefore, today's wage-price spiral in the U.S. works as an "infinite loop" until demand slows significantly, primarily driven by personal incomes. Putting aside how shortages in the supply chain affect inflation, the Fed needs to use monetary policy to lower workers' wages to slow inflation.
The top two sources of income, according to the Tax Foundation, are salaries and capital gains on investments. To lower incomes in both categories, the Fed may have to make changes that exceed many investors' expectations.
For the wage component, the wage-price spiral must end before any easing in wage growth occurs, which means that the U.S. unemployment rate needs to rise.
When a recession is imminent, the Fed usually stops tightening policy. Still, the central bank may continue to raise rates even if the economy flashes more worrisome signs. For example, the Fed has historically tended to stop raising interest rates when the ISM manufacturing PMI approaches 50.0, a key threshold for gauging whether factory activity is in expansion or contraction territory.
The latest reading for the PMI was 50.9 in September, down from 57.6 at the start of the year, after the central bank raised policy rates by 300 basis points during the period. When the ISM manufacturing PMI moved toward 50.0 in 2006, 2015, and 2019, the Fed ended or paused rate hikes on all three occasions.
If the past ISM PMI's impact on rates is any indication, the Fed should be about to stop raising rates. However, the Fed may want to see the index dip into contractionary territory, as a sustained period of reduced business activity is likely to reduce business hiring, one of the most effective ways to end the wage-price spiral.
At the latest Federal Open Market Committee (FOMC) meeting, Fed Chair Jerome Powell said he has always understood that restoring price stability while achieving a relatively modest increase in unemployment and a soft landing would be very challenging. In other words, the Fed may have run out of better options than to plunge the economy into a recession to substantially dampen business activity.
Capital gains on investments are another crucial source of personal income in the U.S., and there are signs that the Fed does not want investors to increase their wealth at this time. In the past, the "Fed Put" was a commonly used term in financial markets to describe the belief that the Fed would step in with accommodative monetary policy to buoy market confidence, specifically in the equity market, if prices fell too fast too quickly.
"Fed puts" have occurred throughout history, such as in 1987, 2010, and 2016, but it hasn't happened this year, even though its major equity indices have fallen into bear market territory. Until today, the majority of top Fed officials, including Powell, have stated that the central bank has not done enough to ensure inflation moves toward its 2 percent target. Moreover, they have shown no willingness to offer financial market support, such as hinting that the tightening cycle is nearing its end or that they may pause tightening.
It would be easy for the Fed to influence stocks at this point. Because of their close relationship with the bond market, the fate of U.S. stocks is primarily in the hands of the Fed. The 2-year U.S. Treasury note, the part of the tenor most sensitive to the Fed's upcoming policy, has had a 0.81 correlation with the S&P 500 since the start of the year.
As long as the Fed sends investors a dovish message at this stage, the 2-year bond yield should fall sharply. However, no "Fed put" has happened so far, which means the central bank doesn't wish the U.S. stock market to recover at this point. With U.S. economic data likely to deteriorate further and more companies set to issue growth warnings in the upcoming earnings season, U.S. equities are skewed to fall further, even at today's much cheaper valuations.
To sum up, the September U.S. jobs report has nearly sealed the deal for another 75 basis point rate hike in November for a fourth straight policy meeting. With such expectations, volatility in U.S. financial markets is unlikely to abate and there are high chances for another record low for U.S. stocks.