If the markets are correct, today's Fed policy statement will announce the penultimate rate hike of this cycle, in the form of a quarter-point expected on March 22. However, Federal Reserve Chairman Jerome Powell may have other ideas. For that reason, the S&P 500 fell back from its six-week high on Monday, but markets rallied on Tuesday after the Employment Cost Index showed weaker fourth-quarter wage growth.
Powell may be making a case for why interest rates need to rise further and stay higher for longer than investors expect after today's rate hike. Still, Wall Street is holding on to its belief that rate hikes will soon come to an end. According to the CME Group's FedWatch page, the odds of a quarter-point hike in March have dropped from 98% on Monday to 83% today.
While the markets may be right, today's Fed meeting is all about policymakers keeping their options open. Beyond that, Powell has no interest in driving up the S&P 500 and lowering Treasury yields.
The key will be how Powell views the balance of risks. If he says the balance is between higher-than-expected inflation and lower inflation amid a weakening economy, the S&P 500 will shoot up. But he's probably not ready to go that far yet, and will continue to say that inflation risks are to the upside.
A clear signal of a rally in the S&P 500 would be if the language that the Monetary Policy Committee expects "continuous increases" in the Fed funds rate were removed from the policy statement. Most expect this wording to be retained.
Fed meeting minutes fire warning shot
The minutes of the Fed's mid-December meeting highlighted policymakers' concerns about an "unwarranted easing of financial conditions" A recovery in financial markets could "complicate the Committee's efforts to restore price stability," the minutes said.
That concern may have been particularly close to policymakers' hearts ahead of this week's Fed meeting. That's because financial conditions identified by the Chicago Fed through Jan. 20 were more favorable than at any time since the Fed began raising interest rates last March.
Still, Powell's 2:30 p.m. press conference at the conclusion of the Fed meeting is unlikely to be the last word on the outlook for rate hikes. The numerous labor market data releases this week are likely to have more impact on the markets than Powell.
Jobs, wage data are key
On Tuesday morning, the Labor Department's Employment Cost Index showed that payrolls rose 1% in the fourth quarter versus the 1.1% expected. However, wages increased 5.1% year-over-year, a slight increase from the 5% growth in the third quarter.
Economists pay close attention to private sector wage growth, except for those in incentive compensation occupations, as this is a good indicator of underlying wage growth. In Q4, wages in this category grew by 0.9%, or 3.6% on an annualized basis. This measure excludes occupations where wages are determined by commissions, which may be more affected by cyclical ups and downs.
The ECI report is all the more important given the Fed's emphasis on the need for lower wage growth to bring inflation back to the 2% target. Powell has stated that moderating wage growth to 3.5% would be sufficient.
With both consumer spending and manufacturing showing signs of weakness, Friday's January jobs report will provide further clues as to whether the economy's last major source of strength is weakening. Analysts expect a solid gain of 185,000 jobs, but average hourly wage growth is expected to slow to 4.4% from 4.6% in December.
S&P 500 setting
On Tuesday, the S&P 500 rose 1.5% following the ECI report. By Monday's close, the S&P 500 had recovered 14% from its October 12 bear market low, but was still 15% below its all-time high.
On Friday, the S&P 500 hit a high of 4094, attempting to break above the 4100 level for the third time since early December. That is the key level to watch now. On Tuesday, the S&P 500 closed at 4076.60, very close to its high of the day.
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