The Fed’s Balancing Act
Yesterday, the Federal Reserve announced a quarter-point interest rate cut—the first in nine months—highlighting the central bank’s growing focus on the labor market, even as inflation remains a persistent challenge. This decision reflects the Fed’s precarious position, as it attempts to navigate its dual mandate of achieving both maximum employment and price stability in a complex, unpredictable economic environment. The move came despite persistent inflation, with recent data showing price increases ticking up. It also signals a shift in the balance of risks, as Fed Chair Jerome Powell acknowledged that “downside risk” to the labor market has become a “reality.”
The Fed’s actions suggest it is currently prioritizing the employment half of its dual mandate, likely influenced by a political environment that has seen intense pressure from the administration. The vote was not unanimous, and internal divisions within the central bank are evident—with some policymakers favoring fewer cuts due to inflation concerns. This disagreement underscores the difficulty of the Fed’s “risk-management” approach, where there is “no risk-free path.” The labor market, which has seen job creation fall below the “break-even point” and unemployment tick up, is now the central focus.
The Fed’s current policy trajectory, prioritizing labor market health over inflation, suggests that sustained higher inflation is the likely long-term challenge for markets. The Fed’s rate cuts—while providing short-term relief to consumers and businesses—may exacerbate underlying inflationary pressures. Inflation has been running above the Fed’s 2% target for more than four years, and some policymakers worry that businesses and consumers are becoming accustomed to price increases, making inflation more persistent. The effects of new tariffs on goods are also complicating the picture, as their full pass-through to consumer prices remains uncertain but likely inflationary.
This delicate balancing act sets the stage for a prolonged period of higher-than-target inflation. The decision to cut rates, despite sticky inflation, signals that the Fed is willing to accept more inflation risk to prevent a downturn in the labor market. This approach could lead to a scenario where inflation remains elevated—eroding purchasing power over time and creating a headwind for the economy and financial markets. If the Fed is forced to reverse course and tighten policy more aggressively later to combat runaway inflation, it could risk triggering an economic slowdown or even a recession.
Implications for the Stock Market
Another significant concern is the rising risk of a stock market bubble, which appears to be largely supported by two key pillars: AI-fueled capex investments and retail spending driven by high-income earners. The stock market has rallied in recent weeks—even as economic fundamentals have softened—a phenomenon that has raised questions about its sustainability. This rally is heavily concentrated in a few technology companies benefiting from the AI boom, with a wave of optimism around how artificial intelligence could transform the business world. This has led to a market environment where the health of the AI theme seems to be more important to market performance than the health of the broader economy.
Below is a chart of the S&P 500 Price to Sales (P/S) ratio since 1999. This is one broad measure of the stock market’s valuation relative to its own history. While no one can consistently predict market tops and bottoms, the stock market is now trading at 3.29X, which is higher than the previous record of 3.26X set in August 2021 and the highs set during the last days of the internet bubble in 1999. The stock market may continue its upward march for several more years—no bell rings when the stock market peaks. However, this is a good time for investors to reevaluate asset allocations and levels of risk tolerance for their own financial situations, as valuations stretch into record territory.
S&P 500 Price to Sales Ratio (1999-present)
Data Source: FactSet, Tower Bridge Advisors
While the Fed claims it has “no view” on asset prices, its policy of rate cuts is contributing to this environment. Lower interest rates encourage borrowing and risk-taking, which can fuel asset price bubbles. The Fed’s history of creating and then cleaning up market messes—such as the housing crisis caused by holding rates too low for too long—casts a shadow over its current stance. Powell’s deflection on the topic of bubbles is telling, and suggests a lack of recognition of the risks at play. The Fed, in its attempt to stabilize the labor market, may be inadvertently inflating a stock market bubble that could lead to a sharp deleveraging and downturn.
The Stock Market Reflects the Economy over the Long Run
The stock market’s reliance on a narrow set of drivers—AI investment and high-income consumer spending—makes the current rally particularly vulnerable. A slowdown in capex spending or a shift in consumer behavior could expose the underlying weakness of the broader economy. With the Fed’s policy path uncertain and economic data offering contradictory signals, the market is betting on a “soft landing” and a continued series of rate cuts. However, if this optimistic scenario fails to materialize—perhaps due to a stubborn spike in inflation or an unexpected economic shock—the market could be set up for a significant disappointment.
The Fed finds itself in a challenging, complex situation, caught between its two mandates. Its current bias toward the labor market, while understandable, risks entrenching higher inflation as a long-term economic challenge. This policy—combined with a speculative fervor around artificial intelligence and a market supported by a narrow slice of the economy—is increasing the risk of an asset price bubble. AI’s impact on labor markets and the extent to which AI investments can be monetized over time will matter eventually. The Fed’s inability or unwillingness to acknowledge this risk is concerning. Investors should remain cautious by limiting overexposure to risky investments, as the current market rally extends further at these record high valuations. In my view, the stock market is very susceptible to a change in the Fed’s course or a shift in the underlying economic landscape.
Birthdays:
Singer Frankie Avalon turns 85 today, actor Jason Sudeikis turns 50 and actress Aisha Tyler turns 55.
Christopher Gildea 610-260-2235