I can’t help but think that all this Fed action is just so predictable. Why should the markets move at all if the Fed simply meets the expectations? I think it should be differences between consensus and the outcome that surprises investors and moves markets.
No surprises from yesterday’s policy action. Fed Chairman Jerome Powell announced a widely expected Fed Funds Rate increase of 0.75%, again. That puts the current Fed Funds Rate at 3.75% to 4% and represents a 4% increase from just 9 months ago. Given that interest rate policy generally takes about a year to sink its teeth into the economy and earnings, this is a fast start.
Yesterday’s surprise was that investors were likely expecting the Fed to “soft talk” an end game for rate hikes. Instead, we received more tough talk. This inflation shock is not nearly over yet was the inference from the Fed’s speech. Investors didn’t take this reality check kindly.
What is the guidance from here? What is expected, and what is likely to be a surprise?
I assume the Fed’s plan is a “soft landing” whatever that is. Somehow, they cause just enough demand damage to slow inflation, but not so much to cause an economic or earnings recession. All the while, the real problem of a supply shock maybe just needs more time to work itself out. I need more clarity please.
Here are my eight takeaways:
- Just as in the 1970s, supply shocks are a significant contributor to our current inflation cycle. Supply shortages set this inflation cycle in motion. COVID-19, supply chain issues, a war, and worker shortages have all impacted the supply side of the inflation equation.
- The Fed on the other hand can only influence the demand side to the equation. By raising interest rates, the Fed is in effect leading us into a demand contraction. Higher interest rates lead to less borrowing, less spending, less risk taking, less money supply, lower asset prices, and negative sentiment. It’s all they can do.
- The Fed cannot influence policies or speed up time to solve the supply side issues.
- If lowering inflation is the goal, the below chart is the Fed’s inflation path. If the Fed has modeled this correctly, inflation should already be on the downward trend. Below is the Fed’s PCE estimated path.
- Historically, the Fed has been effective at inducing economic slowdowns and asset prices contractions. Almost all rate hike campaigns have ended in economic or earnings recessions. Once the interest rate policies start to bite, inflation can fall quite rapidly. I have no reason to expect a different outcome this time around.
- The two-year treasury bond yield of approximately 4.5% can be a good estimator of where the Fed Funds Rate should be 1 year from today. This logic implies one more rate hike from here. However, the Fed seems to be implying at least two more rate hikes.
- I believe capital markets prices should lead the economy and Fed actions. At times like this, I cannot stress this enough. In my opinion capital markets should turn, or at least find solid footing, before the problems are solved. Need more evidence?
- What are the Federal Reserve Bank outcomes from here that could move markets?
- Fed policy starts to take effect, and inflation starts to fall. The Fed slows their path, or even just talks about slowing the pace of rate hikes. This should be a positive for both stock and bond market pricing.
- Inflation ends up being more persistent than is generally accepted. Or the Fed’s demand side policies do little to heal the supply side issues. This outcome is what the Fed tough talk is inferring. Capital markets do not like this outcome.
- The Fed is moving too fast, and tight monetary policy has yet to influence inflation. The risk here is that the Fed is overtightening. This too has a positive endgame, as inflation falls faster than expected, and the Fed has to pause, or even backtrack on rate hikes. This is the outcome that I am leaning into.
As always, if you would like to discuss this topic in further detail, please feel free to reach out to me.
 Source: YCharts
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Personal Consumption Expenditures Price Index, Excluding Food and Energy is a measure of prices that people living in the United States, or those buying on their behalf, pay for goods and services. It’s sometimes called the core PCE price index, because two categories that can have price swings – food and energy – are left out to make underlying inflation easier to see.
Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.
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