Decision Day for the Fed
The 10-year US Treasury yield rose this week to the highest level in almost two decades during a bruising global bond selloff. This has been driven by booming capital investment, rising government debt, and soaring energy prices that are exacerbating inflation expectations. The 10-year yield, which serves as a benchmark for borrowing costs such as mortgages, broke through the 5% barrier this week. This came after oil prices jumped further as the conflict in the Middle East widens. Traders see a greater than 90% chance of a quarter-point interest rate increase today and another hike by the end of the year. The question remains, however, whether this is a “credibility” rate hike by the new Fed Chair or the start of a longer hiking cycle.
Federal Reserve Chairman Kevin Warsh has expressed skepticism about the effectiveness of a symbolic rate hike. However, Warsh also noted that there should be no misunderstanding about the Fed’s price stability objective of 2 percent: this is a firm, fixed target. Historically, the Fed has only once raised rates in a one-and-done fashion since the fed-funds rate became the primary tool for influencing borrowing costs. A second rate hike may have to wait until after the midterm elections.
The Look-Through Doctrine
The current debate centers on the reaction of central banks to supply shocks, such as a sudden spike in oil prices. Policymakers have long believed these supply shocks to be fleeting. Therefore, hiking interest rates to counteract them could do more harm than good. Economic growth and labor markets could be negatively impacted by higher interest rates, while simply waiting out the oil shock may suffice. The Middle East conflict has kept energy prices elevated for long enough that they are now seeping into household and business psychology, and may make high inflation more persistent. The look-through doctrine was always premised on the idea that inflation expectations were well-anchored and that consumers and businesses believed these disruptions would indeed be temporary. Central bankers could be counted on to bring inflation back to normal if needed. That faith has been shaken. The greater risk now is inaction, even if tighter policy spreads economic pain through higher borrowing costs and weaker growth. Already this morning, mortgage applications to purchase a home were reported as down 19% over the prior year.
The Fed, under Alan Greenspan, cut rates in the early 1990’s as the Gulf War sent oil prices soaring and headline inflation higher. Inflation proved to be short-lived. The same proved true when former Chair Ben Bernanke held rates steady in 2011 as oil spiked amid the Arab Spring. By contrast, in the last several years households have experienced the Covid-19 supply chain snarls, the Russian invasion of Ukraine, an artificial intelligence-induced demand shock, a year and a half of ups-and-downs in tariff rates in the US, and the Middle East conflict. The concern is that this current oil shock could drag on for a while longer.
It does not help that a potential rate hike is being considered during a seasonally weak period and a month away from the next corporate earnings reporting season. Higher rates will not produce more barrels of oil. Even so, central banks worldwide are abandoning this decades-old doctrine to address a conflict that has dragged on for six months. Despite sticky inflation and energy market disruptions, the S&P 500 is up 11% year to date and off only about 3% from its all-time highs.
The Food That Never Arrives
In South Korea, there are internet sites known as “dopamine sites” that allow users to shop online without actually buying anything. One of them is called Food Never Comes. You order food, which does not arrive, but you do not pay for it either. Another site is a mock e-commerce platform that mimics discount shopping apps, allowing users to load up a virtual cart with clothing, makeup, and gadgets without checking out. The reward response comes from the anticipation of the reward, like browsing, building a cart, or tracking a package, rather than actually owning the items. Window shopping has certainly been a popular pastime without an internet connection. It is hard to imagine that many people would be willing to pay a company to make them hungry or to not deliver the goods, but stranger things have occurred in this economy. Expectations for an interest rate increase by the Fed have been high over the past year, without being delivered. Right now, markets are suggesting that the cart is loaded, and an interest rate increase is due to arrive today, whether we like it or not.
Singer Nick Jonas turns 34, Amy Poehler turns 55, Molly Shannon celebrates 62, and golfer Bryson DeChambeau takes a swing at 33.
Christopher Crooks, CFA®, CFP® 610-260-2219