Capital Market Comment
September 7, 2022
Frank Mastrapasqua, Ph.D.
Principal, Chairman & Chief Investment Officer
At the August 26, 2022, Jackson Hole conference, the Federal Reserve was determined to convince the public that it will utilize its tools to reduce demand to achieve its 2% inflation target. The apparent tough language employed by Chair Powell in his speech was clearly designed to focus on containing inflation expectations—making sure that those expectations remain anchored.
The reference to Paul Volcker’s quote on “inflation expectations” at the height of the Great Inflation in 1979 had a purpose but appears to have been unsettling to many market participants. Elevating the 1970s in the minds of investors may have invoked fear and a connection to that period that went beyond Powell’s intent. As a result, failure to provide the context of that time only added to uncertainty.
That period was very different from the experience of the last several years. Having been active as an economist and strategist during the 1970s, I saw firsthand the policies and events that produced one of the most difficult periods for our economy and the American people. As currency crises emerged, the international financial structure was changed. We decoupled from gold and moved to a flexible exchange rate system. This move was a dramatic departure from the system created at the Bretton Woods conference in 1944.
At the same time, various forms of controls were imposed on the economic system by both Nixon and Carter, thus usurping the national flow of capital and creating a misallocation of resources. The pressure on the Fed under Burns during Nixon’s reelection in 1972, followed by G. William Miller’s appointment under Carter and the currency crisis that ensued, placed the Fed in a particularly difficult position. At the same time, the U.S. was in the midst of the Iranian hostage crisis, which lasted 444 days, ending in January 1981. The appointment of Paul Volcker, then president of the New York Fed, in August 1979 as Fed Chair was an attempt to stabilize the currency market, given his international experience.
The Volcker era brought about a dramatic change in the way monetary policy was conducted. After years of targeting rates, the Fed shifted to targeting money supply, and interest rates would be a byproduct of its ability to meet money supply objectives. This shift created rate volatility and near chaos ensued when controls were implemented in 1980 by the Carter Administration. Short-term interest rates plunged 1000 basis points (10 percentage points) in six months, then rose by 1000 basis points (10 percentage points) over the next 12 months, leading to the infamous 21% prime rate.
A lot of dissension existed at the Fed, particularly as massive unemployment developed. The period was marked by crises, domestic and international, financial structure reforms, and policy mistakes.
Although our current period has its own unique circumstances (COVID pandemic, Ukraine war) and the policy missteps associated with those circumstances, the references to the 1970s certainly has rhetorical value, even if the fact patterns do not correlate. However, the Fed’s attempt to communicate a level of seriousness left facts and reality wanting.
Despite the Fed’s continued focus on robust employment numbers, the economy is in fact slowing. After two negative GDP quarters, Q3 is estimated to rise only 1.36% by the Federal Reserve Bank of Atlanta. Pockets of weakness are appearing in subsets of the economy, such as housing and retail. There is a changing mix of consumer preferences, a softening in parts of technology (particularly those related to consumer products), and a slowing in the investment cycle and in trade. In July, the first month of Q3, personal income rose a meager 0.2% and personal spending barely increased by 0.1%. The PCE core deflator rose only 0.1%, while the overall deflator declined 0.1%. The effect of the Fed’s actions and expected actions are already being felt across the economy. Also, the lagged effects will be with us for some time. If the outsized rate increases occur, particularly at the next two FOMC meetings, the monetary authorities will be on their way to “overkill”.
The central bank is making projections from economic and monetary models that have had difficulty capturing the changing underpinnings that technology has imposed on the U.S. economy. For over a decade, the 2% inflation rate target could not be attained. As a result, concern about deflation persisted. The post-pandemic period posed a different set of problems. An assessment of inflation that was transitory had to be changed and thus created a new focus for policy. The rate forecasts that emanated from the changing economic dynamics became very difficult to make and were subject to change. For example, as recently as 2018, after nine rate increases from the end of 2015, and the expectation of three or more in 2019, the Fed followed with no rate increases for seven months, and then rate declines.
Moreover, the notion of the neutral rate, one that is neither restrictive nor easy, is elusive. It is not known, but more importantly, it is constantly changing in the dynamic economy. Continually mentioning the neutral rate gives it a level of significance and perceived clarity that can be misleading. The speed with which the Fed has chosen to raise rates and the unprecedented magnitude of the increases will have consequences that are yet to be determined.
The Fed has decided to raise rates sharply and quickly, yet the basis for these decisions is harnessed to forecasting mechanisms that are limited. The scenario presented by Powell, and the FOMC forecasts, though plausible, will likely stray far from the mark.
The economy is changing rapidly. The supply chain is loosening, commodity prices have fallen, freight rates are receding quickly, even before additional financial stress emerges. With all the talk of inflation, the behavior of money supply is going unnoticed. After the surge during the pandemic, monetary supply has slowed to a 5 to 6% year over year growth rate as of July 2022.
More important, money growth has stagnated—no increases over the last five months. This stagnation is either because of current Fed policy, or the emerging economic weakness, or both. The markets have reacted to Powell’s comments and those of other Fed spokespersons.
The near one-dimensional focus on the 2% target and the growing acceptance of economic weakness that might be necessary is likely to come under scrutiny in the coming months. Although employment grew a solid 315,000 in August, the unemployment rate rose from 3.5% to 3.7%. Although the rate is still quite low, the disaggregated data on the economy suggests that the unemployment rate is likely to rise in coming months.
The Fed’s decision to front-end load rate increases stems in part from the realization that as the economy slows, it will become increasingly difficult to raise rates later. Most likely the congressional chorus will get louder and louder. Like 2019, a pause in the rising rate path for 2023 could easily become the scenario, with the inflation rate beginning to fall. An even earlier pause could occur.
As of Friday, September 2, a one-year break-even inflation rate was 2.11% compared to 6.3% in March, thus suggesting a dramatic drop in inflation expectations. The recent pullback in the equity market, particularly since Jackson Hole, has increased investor fear and is reflected in rising negative investor sentiment. Over the near term, near record lows for investor bullishness (a contrary indicator), coupled with technical indicators (put/call ratios, oscillators) that are reflecting oversold market conditions, indicate a respite may be at hand. Over the longer term, a 3 to 3.5% ten-year treasury yield, a strong dollar, and an S&P 500 earning yield of 6%, should provide market support. With the market factoring in what appears to be the worst-case scenario from the Fed, a change at the margin could produce positive upside momentum. The July rebound was just such an example.
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