“When the time comes to raise interest rates, we’ll certainly do that, and that time, by the way, is no time soon.”
Federal Reserve Chairman, Jerome H. Powell, January 13, 2021
The Federal Reserve (Fed) created a monetary policy exit ramp at the Jackson Hole Economic Policy Symposium in August 2020 and they may be about to use it. Back then, the Fed formally agreed to a policy of “average inflation targeting,” meaning that it would allow inflation to run “moderately” above the 2% goal “for some time” following periods when it had run below that objective.
The challenge for investors is that the Fed cleverly didn’t provide much guidance on how hot it would allow inflation to run — or for how long. But we’re all about to find out.
Despite the Consumer Price Index (CPI) hitting 40-year records, the Fed’s preferred inflation gauge, the Personal Consumption Expenditures (PCE) Index excluding food and energy, has slowed each month since peaking in February, falling from 5.3% to 4.7%.1 The University of Michigan’s long-run consumer inflation expectations measure also slipped from 3.3% to 3.1%, easing fears that soaring inflation was becoming dangerously entrenched.
The Fed’s interest rate hikes in March, May, June and July — with more expected at future Federal Open Market Committee (FOMC) meetings — combined with slumping commodity prices, including for oil, will likely lead inflation barometers to fall further. Exactly the outcome the Fed desires — stable prices.
Figure 1: Conference Board US Leading Economic Indicators
Yet, despite the PCE Index’s recent deceleration, continued aftershocks from the global pandemic (i.e., supply chain bottlenecks, rising wages and skyrocketing rents), the Russia-Ukraine war and China’s unwillingness to ditch their zero-COVID policy will likely keep inflation above the Fed’s target.
Naturally, market participants expect the Fed to continue aggressively raising rates to defeat stubborn inflation. But for how long? Global manufacturing and services surveys continue to show a significant slowdown in economic growth. The US 2-year/10-year Treasury yield curve remains inverted — often a harbinger of recession.
Initial jobless claims have increased by 50% since early April, reaching 256,000 on July 28.2 The Federal Reserve Bank of Chicago’s National Activity Index suffered its first back-to-back negative readings since the start of the pandemic in early 2020. Housing data is falling off a cliff. US single-unit housing permits fell 8.0% month-over-month in June. Existing home sales declined 5.4% month-over-month.3 And, the National Association of Home Builders/Wells Fargo Housing Market Index plunged to 55 in July, to the lowest level since May 2020.4 The US economy is already in a technical recession, defined as two consecutive quarters of negative growth in real GDP.
As for the capital markets, the Fed isn’t concerned about a little volatility, especially with stocks. In fact, the Fed likely welcomes some air being let out of some of the more egregious portions of the everything bubble such as SPACs, NFTs and cryptocurrencies.
There are, however, two things that the Fed cannot and will not tolerate. First, the Fed’s responses to crises from the Savings and Loans Crisis to the COVID-19 pandemic show that it will work to stop any disruption to the smooth functioning of the credit markets. The Fed also will combat a severe weakening of the labor market (i.e., surging job losses and a rapid increase in the unemployment rate) by quickly easing monetary policy.
The odds of one or both of these politically untenable threats occurring increase with each 0.75% increase in the target federal funds rate. As a result, despite inflation remaining above the 2% average inflation target, the Fed is going to need an exit strategy very soon.
Ironically, the Fed could use forward guidance at this year’s Jackson Hole Economic Policy Symposium in late August to signal that a higher post-pandemic inflation target is justified given the benign inflation environment of the previous decade. That’s how the Fed magically and prematurely declares victory over inflation — it simply moves the goalpost.
Investors eager to reach the end of the Fed’s monetary policy tightening cycle will celebrate by sending risk assets higher. Even as inflation decelerates, it will likely stay above the Fed’s 2% inflation target in the post-pandemic environment.
Still elevated inflation and a shrinking economy create a Catch-22 for the Fed. In the end, Chairman Powell is human — meaning he ultimately may revert to the path of least of resistance. Declare victory over inflation and keep interest rates artificially low to boost financial asset prices. And regrettably, Powell will have missed an opportunity to break the cycle of monetary policy leaders thinking the Fed could and should use its power over interest rates to produce desirable economic outcomes.
Figure 2: US Wealth Growth vs. US GDP Growth: Normalized, Base = 0
As the economic data worsens, I expect the Fed to adopt an increasingly flexible stance on the average inflation target. This isn’t the best outcome. It’s just the most likely one. By claiming a false victory over inflation and kicking the can further down the road, economic risks won’t stabilize, they will grow. Supported by monetary policy, household wealth cannot continue to grow at a greater rate than the economy. And, when the day of reckoning finally arrives, it will be much worse than it would have been had the Fed stuck with getting inflation under control in the first place.
1 Bureau of Economic Analysis, June 30, 2022.
2 US Department of Labor, July 28, 2022.
3 National Association of Realtors, July 20, 2022.
4 Dan Burns, “U.S. home builder sentiment plunges, services activity in New York region stalls.” Reuters, July 18, 2022.
Consumer Price Index (CPI)
Inflation measured by consumer price index (CPI) is defined as the change in the prices of a basket of goods and services that are typically purchased by specific
groups of households.
GDP Gross domestic product is the standard measure of the value added created through the production of goods and services in a country during a certain period.
Inflation An overall increase in the price of an economy’s goods and services during a given period, translating to a loss in purchasing power per unit of currency. Inflation generally occurs when growth of the money supply outpaces growth of the economy. Central banks attempt to limit inflation — and avoid deflation — in order to keep the economy running smoothly.
NFT A non-fungible token is a digital asset that links ownership to unique physical or digital items, such as works of art, real estate, music, or videos.
SPAC A special purpose acquisition company is a company without commercial operations that is formed strictly to raise capital through an initial public offering (IPO) or the purpose of acquiring or merging with an existing company.
The views expressed in this material are the views of Michael Arone through the period ended July 28, 2022 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward looking statements.
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