Stocks fell modestly yesterday as investors anxiously awaited the outcome of the two-day FOMC meeting that will end today.
There are actually two events of note happening today. One, just noted, is the FOMC meeting. The other is the first face-to-face meeting in Geneva between Vladimir Putin and President Biden. While the latter could have meaningful long-term political consequences, it is unlikely to move the economic needle. Thus investors, like everyone else, will watch with interest, but their focus will be on the Fed meeting.
The media has touted today’s meeting as the most important since the start of the pandemic. In reality, that is a huge overstatement. The Fed today will actually do very little. It won’t raise rates, although they might make a technical adjustment or two that could move the Fed Funds rate to the middle of its intended 0.00-0.25% range from the lower end of the band. What everyone will be watching for is messaging that will signal when the Fed might start to moderate the pace of bond purchases and when it might begin raising rates. Thus, today will be a no-action meeting, but the significance will be whether the Fed gives any hints as to when and under what conditions it might take future action. Given that markets are forward looking, any changes in the perceived road map will be market moving.
Let’s start with where the roadmap was before this week’s meeting. While the Fed doesn’t have a precise written map published, the general consensus has been that it might begin the discussion of tapering the pace of bond purchases sometime around its August conclave at Jackson Hole. Actual tapering wouldn’t begin until sometime close to the end of the year. The Fed for months has acknowledged that there would be a spike in the rate of inflation as the economy reopened. The pace would be accelerated temporarily by supply chain difficulties related to the rapid recovery. Indeed, inflation data has proven the Fed correct, but perhaps too correct. Some argue that the pace is a bit hotter than originally forecasted, and that it may not be entirely as transient as the Fed predicted. If that school of thought is correct, the Fed might be forced to act sooner than originally intended.
Thus, the Fed has to walk a tight line. Or rather, Chairman Jerome Powell, in today’s post-meeting press conference, will have to do the tiptoeing. Any indication that the Fed is more concerned about today’s inflation pace, and might consider slowing the pace of bond buying sooner or raising rates before the end of 2023, will not be well accepted by markets. Markets want low rates forever with no inflation. That may be impossible but those are the ideal circumstances. Investors don’t want to hear otherwise.
On the other hand, many fear that if the Fed sits back and allows inflation to get too hot, it will find itself behind the curve, a self-imposed curse that often happens to the Fed. That would require more aggressive future steps to curb inflation that could squelch the economic recovery and lead to a correction, or even a recession.
Thus, too strong a statement would make investors worry that a Fed response would be accelerated and spoil the party, while failure to acknowledge that higher than expected inflation readings need to be investigated to see if they are transient or not will worry others that the Fed is rapidly falling behind in its mandate to maintain a stable currency. The path in between is narrow.
That’s the map for today. Powell may or may not find the narrow center. In reality, however, he still has plenty of time to begin or moderate the tapering process. But markets have little other news here in early June to stew on. So, today’s comments take on outsized importance.
The reality is that some of the inflationary pressures are transitory. During the pandemic, as companies shut down and cut off their own revenue sources, the need to conserve cash was urgent. In the spring of 2020, no one knew how long the shutdown might be or how long it might take to recover. To raise cash, every sales dollar went straight to the piggy bank. No need to replenish inventories if there were no sales. Thus, inventories fell to rock bottom levels.
Now fast forward to January 2021. The spike in infections was beginning to wane. Vaccines were arriving. In just a few short months, the economic doors reopened. People ventured out. Winter ended. Malls reopened. If vaccinated, you could start to eat indoors. By late spring the cutout figures in stadium seats were replaced by real people. Real people bought food, clothes, and airline tickets. They even bought houses. Suppliers were caught short handed. Not enough lumber or copper or oil. Not enough washing machines, barbeque grills or ketchup packets. Everyone had to scramble to catch up. It was a replay of last year’s toilet paper scare. But like toilet paper, the supply shortages won’t last for long. Lumber price futures are already down about a third from their peak even as home construction keeps chugging along. As I have noted previously, there isn’t any shortage of trees. Supply eventually catches up with demand and prices even out. Some shortages will take months to rebalance. A few will take more than a few months. But the shortages caused by inventory shortages or even supply chain disruptions will get solved.
However, that doesn’t mean all inflation is transient. Home prices are not going to quickly return to 2020 levels. Gasoline won’t fall back to sub-$2.00 levels either. Most important the Fed cannot manufacture more workers. While higher wages will entice some to enter or reenter the workforce, they won’t send retiring boomers back to work. Hundreds of thousands who died or were disabled by Covid-19 are gone. We aren’t going to see immigration reform any time soon. It isn’t on anyone’s agenda. Even when rules are loosened to allow seasonal workers, remaining Covid-19 travel constraints interfere. A few years ago, there were 6 million more unemployed workers than there were job postings. Today, there are over 9 million job postings and less than 8 million unemployed. While skills mismatches may prevent every job opening from being filled, it is probably safe to say that if one wanted to work today, finding employment hasn’t been easier than at any time since the Great Recession. To fill jobs, employers have to raise wages. It’s that simple. It is a heck of a lot easier to raise wages than to cut them. The percentage of workers who are quitting jobs today is the highest in recent memory. While some quit out of dissatisfaction, many quit for better opportunities. The easiest way to lose good workers is to pay them less than your competitors. It’s like musical chairs. Employers need to pay more to ensure their chairs are occupied.
That isn’t transient. Simply said, we are living in an economy currently growing 7-10% in real terms on an annualized basis. That rate might subside to something less than 5% by early next year, but our labor force is growing by less than 2%. Short term there might be some slack left to fill the gaps, but clearly an economy cannot grow faster than its labor force for any significant period of time without causing significant upward wage pressure.
It is the Fed’s mandate to get back to full employment as quickly as possible. But modest changes in the pace of bond buying or a quarter of a percentage point change in the Fed Funds rate won’t move the needle dramatically. If the Fed stays in front of the curve, it could help to moderate the pace of growth and stabilize economic growth rates to match the rate of labor force growth, allowing for inflation of about 2%. If it hangs back too long, inflation will blow past its target requiring harsher future action. That is the risk of doing too little right now.
The Fed isn’t going to suddenly change course, not today, not six months from today. A Jerome Powell Fed moves on evidence. Yes, inflation is hot right now, but it needs to see at least a few more months of data to surmise if trendlines are really changing. By the Fall, when schools reopen, we can fly to Europe, and mostly everyone will be back in the office, and data will tell the Fed how much of the inflation is transient and how much is enduring. The future path of inflation isn’t going to depend on whether the Fed begins to taper bond purchases in November, December or January.
But here is the reality. Over the next 12 months, assuming no dramatic Covid-19 resurgence, the Fed will start to unwind its extraordinary easy monetary stance, first by buying fewer bonds and feeding fewer additional dollars into the market, and eventually by slowly raising rates. That is a headwind investors will have to face. A tailwind is much nicer, but that’s the reality. The offset is an enduring economy whose growth rates can offset the headwind of tighter monetary policy. For several decades, the Fed has been able to sustain long term recoveries, first in the 1990s, then in the first decade of the current century, and finally post the Great Recession. Taking small baby steps works best. Limiting market surprises works best. Mr. Powell today will want to let markets know that it sees inflation rising. It will spend a few months to determine how much is transient and how much is systemic. If needed later this summer or in early Fall, they will alter their game plan if necessary.
Today isn’t the day for answers. Despite all the high-profile investment pundits who espouse opinions, the Fed is going to be data driven and take at least another month or two to dig in and learn.
Investors will watch the so-called dot plots of committee members who will predict today when the Fed’s first rate increase will be. The consensus is likely to be somewhere between late 2023 and early 2024. I have news for you – these experts are no better at predicting interest rates 2-3 years from now than you are. Predicting interest rates 2-3 years from now is about as accurate as predicting the weather in 2-3 years. The FOMC members don’t know and their dot plots today have absolutely no bearing on policy decisions six months from now, let alone 2-3 years out. That doesn’t mean the media and economists won’t talk about them. But they are pure noise.
The bottom line is that investors and the media are going to parse every word coming from Chairman Powell today. If he doesn’t slip, markets will breathe a sigh of relief and wait for Q2 earnings in a month. But if his tone is just a wee bit too soft or too harsh, it could be a volatile next few days.
But nothing he says will change the long-term picture. That will depend on actual changes in policy, and none will be forthcoming for a few months at least. Thus, don’t overread market reaction. Long-term rates are tied to actual inflation and Fed policy. Fed policy is to be determined and inflation over the next few months won’t be altered by anything the Fed does or doesn’t do today. The actual tapering roadmap will be explained later this summer. It will be accelerated or slowed as the data dictates. Future rate increases will be used to match GDP and labor force growth. That is likely years away. Today and tomorrow are times to watch the market and perhaps take advantage of opportunities should it overreact. There will likely be more inflation in years to come, especially if Fed action and fiscal policy sustain above-average growth for too long. The trend in rates is higher. I am not an interest rate pundit, but Fed Funds rates are at zero (that doesn’t leave a lot of downside), and long-term bond rates are near historic lows. Thus, simply using reversion to the mean suggests higher rates over time. Near term, I have no idea. But in quiet times, markets tend to overreact to events such as today’s Fed meeting. Watch and take advantage if you can.
Today Phil Mickelson turns 51, but before he goes back to the Senior Tour, he gets a shot at two majors in a row at this weekend’s U.S. Open. My grandson Brooks celebrates his 12th birthday.
James M. Meyer, CFA 610-260-2220