December 15, 2023

Written by: Ryan Kelly, CFA®

Chief Investment Officer, Legato Financial Group

The Federal Reserve operates under a “dual mandate,” meaning they are responsible for managing two important but often competing goals:

1. Price stability (low inflation)
2. Full employment (a healthy job market)

The Federal Open Market Committee’s (FOMC) main tool for achieving these goals is setting the Fed Funds rate, the interest rate banks charge each other for lending excess cash overnight. Changes to the Fed Funds rate echo through our financial system and have a huge impact on interest rates charged to both institutions and consumers, as well as the availability and cost of credit in the market.

Generally, the FOMC committee lowers the Fed Funds rate to increase the availability of cheap credit in the market, increase economic growth and create more jobs. On the other hand, the Fed generally raises the rate to slow down inflation, the economy and hiring.

However, changing the Fed Funds rate is a blunt instrument, and it can take months for the impact of a change to filter through the economy. If the Fed raises rates too quickly, it risks slowing down the economy too much, potentially triggering a recession and increasing unemployment. Conversely, if the Fed lowers rates too quickly, the economy might overheat, and we could face a new pickup in inflation. For example, many traders believe the Fed was too slow to act in late 2021/early 2022. They also believe that if the Fed had raised rates earlier, perhaps inflation would have been slower. Sadly, we will never know for sure if the traders’ thinking is correct.

The Fed has raised rates by 5.25% since March 2022 to combat record inflation. Over the past few months, however, both inflation and employment data points have moved closer to the Fed’s targets. The Fed’s last rate hike was at the end of July 2023. According to futures pricing, interest rate traders are currently betting that the rate hikes are over and that the Fed will start cutting rates during the first half of 2024.* It is vital to remember, however, that a myriad of unforeseeable events could completely change where traders and the Fed expect rates to go. Very few investors have demonstrated the ability to predict future interest rates accurately and consistently.

The Fed keeps a close eye on several important economic indicators to determine the impact of their past policy decisions and set future policy. As a result, traders pay close attention to the same indicators, attempting to divine future market movements and Fed actions.

For example, in the week of Dec. 4, 2023, we got three labor market reports, each of which the Fed used to inform its decision about their next steps: the Job Openings and Labor Turnover Survey (JOLTS), the ADP employment report and the Bureau of Labor Statistics (BLS) non-farm payrolls report.

The JOLTS report is issued by BLS and includes several metrics on layoffs, quits, hires, etc. But the most-watched data point right now is their count of the total number of job openings. This number is seen as an indication of companies’ demand to hire more workers; taken in isolation, a lower number indicates companies have fewer hiring needs, which seems to indicate a cooling economy and job market. The most recent data released on Dec. 5 was far lower than the estimates of all 40 analysts surveyed by Bloomberg.**

The obvious question to all this is, “Isn’t a cooler economy and job market a bad thing?” Well, maybe not – especially once you incorporate the Fed. A poorer-than-expected job market could also be an indicator that inflation is slowing, which might allow the FED to lower rates sooner. If they do, it could mean cheaper borrowing in the future, which many traders see as a good thing.

We’re going to spend a fair chunk of time and energy talking about the Fed and interest rates because they truly are the 800-pound gorilla in the room. We can’t simply look at economic data as good or bad on its own. Rather, we must also look at how the data is likely to impact the Fed and their monetary policy.

*CEM FedWatch tool

** https://www.bls.gov/news.release/jolts.nr0.htm