Today concludes an important 2-day FOMC meeting. The Fed is almost certain to increase the Fed Funds rate by at least 75 basis points. There are a few pundits suggesting a full percentage point is possible in the wake of last week’s surging August CPI report, but the Fed never intends to surprise. A one percent increase would be a surprise, an unwanted one. To the extent the Fed builds trust, it does so via consistent messaging. Thus, a 75-basis point increase is almost certain.
Anyone who watches the stock market knows that the recent pace of interest rate increases in front of today’s meeting has been disturbing to equity investors. The Fed Funds rate was near zero as recently as early March. After today, it will be over 3%. The 30-year Treasury, now near 3.55%, is the highest since April 2011. Inflation is starting to fall. Reported statistics suggest a slow decline. Anecdotal data suggests the decline might be accelerating. Frankly, it’s a confusing picture. Key commodity prices are rolling over. We all see the declines in gasoline, for instance. Home prices are moderating in many areas. Rents are still rising but at a slower pace. Food prices remain stubbornly high and there has been no apparent slowdown to date in the pace of rising wages. The U.S. has evolved over decades into a service economy. Wages and rents are dominating influences.
Wages are also a lagging indicator. One doesn’t ask for a 6% wage increase when inflation is zero. A 6% ask is virtually always in response to higher cost of living. If the cost of living comes down, wage increase requests will follow…with a lag.
There is also a lag between the time the Fed raises interest rates and the economic impact of such increases. Thus, the Fed’s job is to set policy for the future without knowing exactly how the economy will react months from now. It is what makes its task so hard and why, so often, it misses the target.
Essentially, the economy could follow one of two paths forward. The first is the targeted path of a soft landing. In this scenario, the Fed raises rates above neutral, the economy slows down, job growth falls to near zero (below a level necessary to sustain growth), and economic growth slows to near zero as well. Gradually inflation falls back toward the Fed’s 2% target. As inflation falls, interest rates will moderate. Profits will hold fairly steady. After a year or two of below trendline growth, enough slack will evolve that will keep inflation at bay assuming that the Fed and/or Congress does nothing to stimulate growth fast enough to reignite inflation. This is indeed the Goldilocks scenario. Possible but not the most likely one.
The second outcome says the Fed goes too far. It raises rates too fast or too high. Employment growth doesn’t slow; it contracts. Profits fall. Recession is inevitable. As in an auto crash, the severity isn’t determined by how hard you step on the brakes but by the damage incurred by the resultant collision.
The Fed was as much as a year late tightening the money supply. It has tried to catch up by raising rates at the fastest pace since Paul Volcker’s tenure at the Fed. In percentage terms, the rate of ascent in rates may be the highest in the Fed’s history. In an economic world, sudden change is never received well. It is jarring. Inevitably, something breaks.
If you have been watching markets in recent weeks, it is easy to conclude that Scenario #2 is virtually a given, but that’s not necessarily so. Just two months ago, markets thought the soft landing was likely. One CPI report changed that. In the real world, there is no stark difference like what might have seemed apparent reading the July and August CPI reports. Combined, they told us, reducing inflation is a process. It didn’t build up overnight, and it isn’t about to disappear in a month.
As we discussed Monday, neutral is the rate that neither accelerates or retards economic growth. The Fed clearly is targeting a Fed Funds rate of 4% or higher (some now say 5% or higher). That is well above long-term inflation forecasts. It is beyond forecasts for the rate of inflation a year from now. Clearly 4% or more is above neutral. The economy will slow as long as it keeps rates that high. The key is when will it be time to release the pressure. Given that it took as long as a year for the Fed to assess the need to tighten, the majority of observers think it will stay tight too long. Right now, the Fed appears to be singularly focused on the pace of inflation. Leadership has said it wants to see inflation come close to target for an extended period. Given the lags in wage demands, and to a lesser extent, rents, does that almost certainly mean a recession is inevitable?
In a static world, the answer would be yes, but that assumes experience doesn’t allow one to learn and adjust. The Fed members see what we all see. They aren’t smarter or less smart than we are. They know key components like wages lag. No one said wage increase requests have to fall to 2% before returning rates to neutral. If employment starts to fall for consecutive months, look for the Fed to moderate its pressure. Today, the FOMC members will share their composite outlook, the so-called dot plot. Wall Street will pay attention and markets will react, perhaps violently, but go back and look at dot plots from past meetings. The Fed has no clue what it will be doing a year from now. The FOMC members are all being asked to make guesses that have virtually no basis. The dot plots send a message investors will react to, but it is a very bad message. The only certainty is that over the next year, the dot plots will change a lot and so will Fed actions.
Jerome Powell is right when he says policy decisions are date dependent. The August CPI report is real data. A prediction of the inflation rate next August is a pure guess. It isn’t the basis for any policy decision today.
Markets today and tomorrow are going to react to the composite near-term outlook Jerome Powell lays out at his post-meeting press conference. He wants to sound tough, that the Fed is all in fighting inflation. He has said in the past that some economic pain might be necessary to reach that goal. To most, pain means recession. A weaker stock market aids his flight to lower price pressure. Less net worth means less spending, but neither he nor any member of the committee sees the need to crush the economy to get inflation down. In some cases, inflation is more a result of supply shortages than excess demand. The supply chain problems that were pandemic-related are slowly getting resolved. Shortages from bicycles to computer chips are being resolved, but there are other shortages that can’t be resolved by crushing demand. A recession isn’t going to create more police, nurses, or airline pilots. Congress wants to double the number of IRS auditors, but where are they going to come from? The housing market has suffered from a shortage of inventory for years. Crushing demand for new homes is exactly the opposite of what’s needed to balance supply and demand. Today, we are short workers at the same time legal immigration is at a multi-year low and two million illegal immigrants are entering our country in just one year’s time. Fed policy isn’t going to solve that problem either.
The right policy is to step on the brakes just enough to slow the economy, not destroy it. Maintaining moderate pressure for an extended period would work. That is part of the message the Fed is trying to convey when it says it will keep the Fed Funds rate above neutral for some time.
The bond market will react to these actions. It already has. The Fed essentially controls the short end of the curve, but not the long end. Forget the past decade when central banks kept rates so low that money was free in real terms. All that did was overstimulate. Because there was so much excess capacity post the Great Recession, it took time for the stimuli to create inflation. In a real world with less central bank interference, money needs to have a cost. Long term lenders key off of long-term inflation expectations. Mortgage lenders today want 6.5% to lend for 30 years. That seems shockingly high compared to a year ago. It isn’t shockingly high related to history. As inflation recedes, the rate might moderate a bit, but it isn’t going back to 3% or lower anytime soon.
If I were Jerome Powell today, I would want to emphasize the need for pressure but not radical change. Recession is possible but it shouldn’t be a goal. Soft landing is still the target. If that proves to be a reality, markets should settle down. If, however, he tows too tough a line, investors will assume a recession is inevitable.
I have no idea whether 4% or 5% is the terminal Fed Funds rate for this cycle. The key isn’t the rate; it’s when does the Fed release the pressure? Right now, investors are betting it will wait too long creating a recession of some duration, but markets are wrong as often as they are right. A market bottom in October is consistent with a soft landing. A recession and falling profits mean a bear market for longer and a bottom closer to 3000 in the S&P 500 than 3600. It remains an undefined path.
What we do know is that if there is a recession, it will be a creation of the Fed in reaction to excess stimulation, and it can be terminated by the Fed via easier monetary policy. Unlike 2008 or 2020 any recession isn’t a response to a financial or pandemic crisis. Ultimately, it would be nice to see central banks let markets set future economic paths, only interfering when markets create their own imbalances. Since 2008, central banks have defined the economic path. They have created asset bubbles, inefficient capital allocation, and inflation. Left alone, it seems quite likely that natural market forces could do a better job than central banks.
Today, Fannie Flagg is 78, Stephen King (who has yet another new book out) is 75. Bill Murray turns 72.
James M. Meyer, CFA 610-260-2220