On Monday, stocks fell sharply in the morning, continuing the slide that began on New Year’s Eve, but then they reversed. Equities simply fell too far, too fast. The 10-year Treasury yield temporarily exceeded 1.8%, but then started to recede. By the end of the session, most losses had been recovered. A moderate rally continued yesterday. Futures this morning point to further recovery. The gains over the past three sessions were broad based.
Jerome Powell spoke before Congress at his confirmation hearings. He took a somewhat stern tone toward inflation, but didn’t hint of any further acceleration of the tapering process, nor any interest rate increases beyond what markets are currently forecasting. The report on consumer prices for December will be released today. It should be ugly. Inflation is everywhere now and is accelerating. Some of it may be temporary, tied to supply chain disruptions. But it has become more than simply that. Wages are accelerating. Home prices and rents continue to skyrocket. The sharp drop in the unemployment rate suggests full employment is at hand. The pace at which people are quitting jobs to move up the ladder is at a record pace.
No, the problem today is that demand is too strong. Demand may be pinched a bit by Omicron. However, most everyone expects Omicron to be in noticeable decline a month from now. More variants may follow…or not. Mother nature, not market forecasters, will be responsible for the virus’s next step. But we are learning to adjust and move on. Restaurants and planes aren’t as full as they were a month ago, but they aren’t the ghost town they were 18 months ago.
Slowing demand is the job of the Fed. Its toolbox includes changes in interest rates and the size of its balance sheet. To fight the strongest inflation in 40 years, it will need to raise rates and reduce the size of its balance sheet. It must make money less plentiful and more expensive.
The Fed helped to lift asset prices for a decade by flooding markets with money and setting short-term interest rates near zero. It succeeded, but it let the party go on too long. That is what has led to inflation today. Yes, the recovery from the pandemic may have accelerated demand for a while, but market forces didn’t create negative real interest costs, making borrowing “free”. Market forces for the last six months didn’t expand the money supply at a steady 13% clip, the Fed did that.
Now with inflation at a high single digit pace, the Fed must put the lid back on the cookie jar. It wants to do so at a measured pace to keep markets calm, to lead everyone to believe that it has all things under control. It wants us to believe that it can ease its foot off the accelerator at just the right pace to allow the economy to grow slower, but still faster than it has for the past decade. At the same time, this deceleration will let inflation slowly subside back to the 2-3% pace that would allow us all to be comfortable.
It wants to stop a runaway train by gradually easing up off the accelerator.
That’s quite a task. History suggests that won’t be easy. So far, the Fed hasn’t so much as tapped the brakes. It is still buying bonds and adding to its balance sheet, albeit at a slowed pace. Interest rates controlled by the Fed remain at zero. It will stop buying bonds in March. It will begin to raise rates then. It should do both today and stop with trying to put forth an image of calm.
The recent drop in the market reflects these fears. The moderate rally this week may have signaled that stocks fell a bit too far, too fast. The key to this market is all about how well the Fed does in its battle against inflation, and the truth is that it hasn’t started to fight yet. Supply chains may heal over the coming months offering the Fed some support in its fight. But make no mistake, the cure is raising the cost of money to the point where the temptation to borrow is reduced. The cure will be aided by less money falling from the sky. President Biden still wants more entitlements. I don’t want to argue for or against any program other than to say more spending today won’t cure inflation.
Inflation has one positive attribute. It lifts reported earnings for most companies. But that is a shallow argument. Rising wages are great, but not if they happen while the cost of living rises faster than wages. Asset prices and earnings might increase, but increases slower than the rate of inflation won’t give investors more purchasing power.
As the battle continues, or rather gets started, markets will rise or fall depending on its success. That battle is going to take months. It may take more than a year. Expect volatility in the interim.
Today, Jeff Bezos is 58.
James M. Meyer, CFA 610-260-2220