It was an up week to start 2023. A good beginning is always a good sign. With that said, it was an up and down week punctuated at the end by a solid reaction to an employment report that indicated that wage pressures are receding a bit. Headcount growth of 223,000 jobs was still a bit higher than the Fed would want to see on an ongoing basis, but it represented the sixth consecutive monthly decline in the number of gains. Simply continuing at the current pace, job growth would be close to levels consistent with 1-2% GDP growth around mid-year.
Logically, the pace of job growth should decelerate as the impact of higher short-term interest rates takes hold. At the moment, Fed Funds futures suggest a better than 75% chance that rates will be increased another 25-basis points on February 1. After that, it’s a coin toss. If I listen to Fed officials, they continue to suggest that rates will continue to rise until the Fed Funds rate reaches at least 5%. That would mean at least another 50 basis points or more after February. Listening to Fed officials about what might happen beyond the next FOMC meeting can often be hazardous to one’s financial health. That isn’t meant to be a criticism of anyone’s intelligence. It’s meant to point out that predicting precise policy actions more than two months ahead is more a crap shoot than a forecast based on pertinent data.
I want to step back and look back. 2022 was a horrible year for both stocks and bonds. It was the worst year for equities since 2008. For bonds, it was the worst year in memory. That’s what happens when the Fed Funds rate rises by four full percentage points and inflation soars to 9%+. For equity prices, the single most important interest rate, the one that impacts P/E ratios the most, is the 10-year Treasury yield. At the start of 2022, it was about 1.75%. By October, when stocks set their lows, it reached over 4.25%. That fact alone explains the lion’s share of the cause for both lower bond and stock prices for 2022. Earnings last year actually rose. 2022 was all about higher rates, higher inflation, and the need for central banks to go to war against the surge in prices.
In 2023, that war is ongoing, but we already see the impact. 9% inflation is over, commodity prices are falling, and goods prices are either falling as well or rising much more slowly. Now it appears that the pace of service inflation and wage growth is moderating as well. The war isn’t over, but it is clear that the Fed and other central banks will win the battle. The concern is collateral damage. Specifically, what will the impact of tight money be on future earnings? 2022 Q4 earnings reporting will begin later this week. Expectations are low. Going in, the forecast is for a decline of about 4%. If that materializes, it will be the first down quarter since the Great Recession, excluding the impact in 2020 of the Covid-19 quarantine.
With all that said, I want to go back to Fed interest rate policy. Assuming the Fed Funds rate goes to 4.5% on February 1, and that inflation continues to recede slowly, we will finally reach the point where the Fed Funds rate exceeds the rate of inflation. Few borrow at that rate. For most, the cost to borrow is already well in excess of the rate of inflation. If I add in the impact of the Fed’s efforts to reduce the size of its balance sheet by $90 billion per month, no one can question that the policy is now restrictive. Restrictive means headwinds to the ability of the economy to grow at its natural rate, one we calculate to be 1-2% in real terms. That means that under restrictive policy, growth will be less than 1-2% until the Fed takes its foot off the brake and brings rates down to a more neutral level.
Simply said, therefore, there is no need for any future Fed Funds rate increases. One could make a convincing case that the pending 25-basis point increase in February isn’t needed. There is no need for the Fed to cut rates anytime soon either, at least until there is convincing evidence that inflation is headed well below 3%. The question then becomes, what rate is neutral? If demographics and productivity trends suggest that sustainable growth is less than 2%, perhaps closer to 1.5%, then a Fed Funds rate closer to 3% might seem logical.
For almost this entire century, the Fed has vacillated between easy money and tight money. Rarely has it even tried to get to neutral and stay there. Easy money fed the housing bubble, and the speculative phase of 2020-2021. It fed the rise of cryptocurrencies and the boom in SPACs. It created 9% inflation. Tight money created massive mortgage foreclosures and the bust of 2022. When one learns to drive a car or ski downhill, the tendency is to oversteer. The Fed has been oversteering for decades. It’s time to move more slowly and get back to neutral.
In order to stop oversteering, the first step would be to slow the pace of future Fed Funds rate increases. As noted, I would like to see it stop raising rates as soon as now. We know rates are already restrictive. We see job growth slowing. We see inflation slowing. We see earnings growth stopping. 10-year Treasury yields are well below October highs. If the Fed insists on raising rates to 5%+, as some within the Fed suggest, it will only accelerate any pending downturn and force it to oversteer in the other direction eventually. While Fed officials suggest that the first-rate cut won’t happen until some time in 2024, markets are already suggesting there will be a first cut later this year. The market is saying that the Fed was late to start the fight against inflation and now it will stay with its foot on the brake too long. Unfortunately, that aligns with history. The smarter move would be to stop now and let future moves in rates be smaller and more spread out.
The good news is that might actually happen. Don’t listen to what the Fed officials say. Watch what they do. Politically, they are motivated to sound tough while inflation is high. By mid-March, at the second FOMC meeting of the year, there will be a lot more data that will determine policy moves. If trends are moving in the right direction, meaning job growth and inflation are falling, what incentive is there to step on the brake harder? I would argue none. When does one take the foot off the brake? Again, that answer will be data dependent. When should rates be cut? Again, it goes back to the data. If job growth is less than 50,000-100,000 per month and inflation is near 3%, it might be OK to cut rates by 25-basis points and see what happens.
Markets like lower rates, but what would really excite investors is for the Fed to let market forces dictate rates, only stepping in when true imbalance exists. A year ago, markets were overheated. The Fed had to act. Markets are no longer overheated. The need for Fed action is waning. Friday’s rally spoke loudly that the data is starting to show that the Fed could back away. I hope members of the FOMC hear the message.
If you are a music lover, it’s a big day for birthdays. Dave Matthews is 56. Crystal Gayle is 72. Jimmy Page of Led Zeppelin turns 79. Finally, Joan Baez is 82. With Prince Harry all over the media in front of his gossipy tell-it-all to be released in the U.S. tomorrow, I should note that his sister-in-law, Kate Middleton, is 41 today.
James M. Meyer, CFA 610-260-2220