Fed gambles on inflation as it waits for more jobs. As part of its scheduled policy meeting, the Fed announced it will begin reducing the pace of its monthly bond purchases later this month, reducing its current $120 billion a month bond buying pace by $15 billion each month – $10 billion in Treasury bonds and $5 billion in mortgage-backed securities. That’s a pace that puts it on track to finish the tapering process by mid-2022, essentially ending its efforts to keep interest rates low by being the bond buyer of last resort.

The Fed altered its view on inflation slightly, acknowledging that price increases have been more rapid and enduring than it had forecast, but still sees the current bout of high prices a “transitory”. Fed Chair Powell said he expects inflation to keep rising as supply issues continue and then start to pull back around the middle of 2022, right about the time the Fed’s tapering efforts conclude. Fed officials don’t envision rate hikes beginning until tapering has ended.

Our take: For the Fed, it’s all about jobs and inflation. Details from last week’s Fed meeting tell us that the Fed won’t entertain interest-rate hikes until the jobs market heals further, even though inflation could run hot for months. The Fed is essentially betting on a forecast that the knots in the port system, overseas production and the job market begin to unravel next year, easing price pressures while ultra-low interest rates continue to stimulate demand. We agree with that view – we’ve held it for weeks now –  and it seems that markets are coming around to it as well. Before last week’s meeting, markets were pricing two Fed hikes next year, one as early as June 2022, and another at year’s end. Those expectations have eased off a bit, with markets now pricing in later rate hikes, the first occurring sometime in Q3 2022.

While inflation has run above the Fed’s 2% target on a 12-month basis every month since early this year, the most likely factor holding back the rate liftoff is a slow recovery in the jobs market. The market is still millions of jobs short of pre-pandemic levels. The employment-population ratio, for example, stands at 58.7% compared to 61% in December 2019. Several more months of this inflation/jobs creation mix could restore companies’ pricing power, which is already apparent on scarce products, and start to spark fears of runaway inflation. All told, the Fed has now created room for an earlier liftoff in rates if inflation is hotter than expected next year, even if the jobs-market recovery lags. We’re expecting at least one Fed 0.25% rate hike next year, sometime in the fall, with another 0.25% hike now possible in December 2022.

America’s jobs engine added more jobs than expected in October. Nonfarm payrolls increased by 531k for the month, compared to the consensus estimate of 450,000. Private payrolls were even stronger, rising 604k as a loss of 73,000 government jobs pulled down the headline number. The unemployment rate dropped to 4.6% (vs. 4.8% prior), or 7.1% (vs. 7.3% prior) if measured with the pre-pandemic participation rate, an adjustment also preferred by the Fed. The participation rate was flat; prime-aged participation picked up a tenth to 81.7%, still a tenth below the level recorded in July-August, and the 82.9% posted in February 2020. Rising wages, the essential counter to high and rising inflation, also accelerated to 4.9%.

Our take: The latest jobs reading is solid and a significant improvement from the last two months. The unemployment rate inched down, and wages continued to climb. That checks the boxes to indicate progress toward the Fed’s lowered bar for “maximum employment”, which recognizes that participation rates may not return to their pre-pandemic level by mid-2022, and when it’s planned tapering efforts are set to end.

While solid, 531k in new jobs is still far below what was expected just a few months ago and tells us that, despite recent declines in Covid caseloads and the expiration of pandemic unemployment benefits, there’s a lingering hesitancy by many about returning to the labor market. Bottom line? Should the jobs/wage picture continue at this pace, the unemployment rate won’t hold the Fed back from lifting rates in 2022, if inflation runs hotter than expected.

China: A case study in stagflation? There are signs of stagflation in China as prices continue to rise and the latest manufacturing data show production slowing. Stagflation occurs when the economy is simultaneously experiencing stagnant activity and accelerating inflation. The phenomenon was first recognized in the 1970s, when an oil shock prompted an extended period of higher prices but sharply falling GDP growth.

An official survey released on Sunday showed China’s factory activity contracted more than expected in October, shrinking for a second straight month. In contrast, their output price index has risen to the highest level since it was published in 2016. Why it matters: China’s rapid economic ascendance – and robust appetite for buying and holding US treasury bonds –  over recent decades has served to help keep US interest rates and prices for goods low. If China’ stumbles, we will feel it.