The Fed: Behind the Curve on Inflation, But Is the Worst Behind Us

The Fed:  Behind the Curve on Inflation, But Is the Worst Behind Us 

Economic growth has decelerated rapidly, with evidence of contraction showing in a number of places.  July has been a stark contrast to June.

Initial jobless claims have been rising for weeks, reaching 256,000 for the week of July 24^th, the highest level since November 2021.  Despite the high level of job openings, it is unlikely that those individuals filing claims will have the necessary skill sets.  The list of companies that have frozen hiring or have reduced their employment base has been rising—Ford, Tesla, Intel, Meta, JPMorgan, Microsoft, Compass, Redfin, and others.

Moreover, the housing market has been declining, with starts, permits, and home sales falling.  Also, the inventory of unsold homes is rising.  Although the market still appears to be in short supply, falling demand and the change in psychology of the buyers and sellers is causing a significant shift.  Multiple offers and buying sight unseen are gone, and seller disappointment is rising.  Beware of Zillow valuations.

The S&P global PMI survey showed a surprisingly large decline, falling to 47.5 and 47.2, respectively, for services and the composite.  This shift was one from growing to contracting in one month’s time.

Conditions are changing rapidly, and it is particularly evident in the commodities market.  Lumber, copper, raw industrial materials, and gasoline have declined appreciably in the last six weeks.  Despite the effects of the Russia-Ukraine War and continuing supply chain issues, corn, wheat, and soybeans have also declined.  The Fed did not emphasize these developments at the July 27th FOMC meeting.  Given its current one-dimensional focus on inflation, continuing to emphasize the pockets of strength in the economy would allow it to move the federal funds rate toward the neutral rate.  The 2-3% range is the estimate that Chair Powell mentioned at a press conference.  The 75 basis points increase announced at the FOMC meeting moved the federal funds rate into the neutral range.  Keep in mind that this range is just an estimate and one that has been quite elusive.  The Monetary Authorities seemed determined to get to the neutral rate and even beyond to create rate policy flexibility.

However, the economy may not accommodate the Fed.  Given the lagged effects, the rate increases to date could easily reinforce contractionary forces and create a changing employment environment.  Moreover, money supply growth and lack thereof reinforce the bias toward weakness.

The Fed was already late to the inflation battle.  Similarly, if it moves too quickly to increase rates and does not adequately account for the lagged effects, it may also be late in addressing the business weakness.  In our judgment, the rate forecast for the rest of the year and next may not materialize as expected.  Later this year, the changing employment picture could alter policy, possibly significantly.

With all these economic crosscurrents, as well as the underperformance of the European and Chinese economies, the financial markets are attempting to assess and discount these factors.

It is interesting to note that the 10-year treasury remains under 3% and is inverted relative to the 2-year treasury.  The 2-year treasury is essentially at the rate of the 30-year bond.  With inflation rates so elevated, it is surprising that long-term rates are so subdued.  Long-term rates should reflect inflation expectations and/or expected future short-term rates.

Are long-term rates indicating that expectations about future interest rates and inflation are nothing like what many forecasters expect and investors fear?

In the statement from the FOMC meeting, the Fed did acknowledge some softening in economic activity, but highlighted the strength in employment and heightened inflation as justification for the 75 basis points rate increase and the prospects of more to come.  Since the meeting, the GDP report for the second quarter has been released and recorded a 0.6% decline—the second in a row.

Although many prognosticators highlight the two consecutive negative quarters as an indicator of recession, there are many other factors that come into play before one can make this determination.  Employment, as well as broad-based deterioration across many sectors, tend to define downturns determined by the National Bureau of Economic Research (the body that officially denotes a recession).  An actual recession may well become more apparent as the third quarter unfolds.  Currently, we have a bifurcated economy, with weakness in certain sectors, such as housing and nonresidential construction, but strength in others, like consumer services.

From the financial market perspective, the weaknesses are evident—call it what you will. Valuations reflect what we are experiencing, with “bear market” conditions evident since at least November 2021.  Yet earnings, which are being reported at a rapid pace, have exceeded expectations for many companies.  Even those that have disappointed and preannounced only had temporary setbacks.  For example, Walmart, which lowered its outlook a second time and sold off the day of the announcement, has recovered to its pre-announcement level.  The pervasive fear of a broad and major downdraft in earnings that became commonplace thinking does not appear to be unfolding.  The large cap stocks like Apple, Microsoft, Amazon, and Google helped thrust the market higher, creating what appears to be a directional change.  Algorithms, program trading, and momentum hedge funds work both ways.  The speed of the decline and the downside momentum could provide insight into what a momentum change can mean on the upside.

From a fundamental viewpoint, the markets are focusing on the future—the discounting of a change in monetary policy, understanding the nature of the economic landscape, and the level of interest rates.

Regardless of current rate forecasts, many of which have not materialized, the current level (2.75% to 3%) for the 10-year treasury is the basis for discounting earnings.  Given these low levels, the bias is toward growth stocks.  At the same time, these yield levels, and an earning yield on the S&P 500 of 6%, is generally supportive of the equity market as a whole.

Additionally, international capital flows can also be a force supporting asset prices.  The weakness in the Euro and the fragility of its fiscal infrastructure, a concern that dates to its formation in 2000, elevates the dollar.  Moreover, international crises—Ukraine, supply chains, sanctions, and China’s anemic growth (property crisis)—should continue to raise concerns about the dangers abroad.  The resulting flow of funds into U.S. financial assets should place the U.S. dollar as a key stand-alone currency.