by Peter Jones, CFA
Senior Vice President, Equity Research and Portfolio Management
In recent months, investors have understandably been obsessing over the Fed and inflation. This week was action-packed for the markets, with the Fed meeting and October employment report taking place. Writing about the Fed has come to feel like Groundhog Day as the markets continue to react to even the most subtle adjustments to central bank guidance, and as such, it is once again worthy of being the primary topic in today’s To Coin a Phrase blog.
As expected, on Wednesday the Federal Reserve increased policy rates by another 0.75%, bringing cumulative increases this year to 4.0%, the fastest pace of rate increases in the post-WWII era. Once again, many investors clung to the hope that the Fed would signal a pivot in their policy stance. At first, investors were overjoyed by the modest changes in the Fed statement; the Fed finally acknowledged that interest rate increases impact the economy with a lag. In other words, the tightening that has occurred this year has yet to impact the real economy in a material way. The acknowledgement implies that the Fed might want to “wait and see” how the cumulative tightening impacts the economy before going much further. In addition, the Fed statement suggested that rate increases would likely slow down in the near future. Markets interpreted the announcement as “dovish,” which sent the stock market rallying and bond yields actually declining. This shift was short-lived upon Chair Jerome Powell’s address to the media. In the interview, Powell suggested that the “terminal rate,” or the rate at which the Fed expects to cease its tightening campaign, is perhaps higher than previously appreciated. Within minutes, the earlier “dovish” progress was wiped out, and the market declined by 3%.
In our view, the Fed is unlikely to move much beyond the 0.50% increase expected to occur in December. With the aforementioned lag between policy rates and the economy, evidence that inflation is peaking, and a clear slowing in the domestic economy, further material increases in interest rates may no longer be required.
We believe that inflation will trend lower over the course of 2023. Key to that viewpoint is the historical relationship between money supply and inflation (chart below). To quote Milton Friedman, “inflation is always and everywhere a monetary problem.” Over the pandemic, the economy has received an arguably reckless amount of stimulus. PPP loans, stimulus checks, an increase in unemployment insurance, debt forgiveness, moratoriums, zero interest rates, quantitative easing, the list goes on … money printing pushed money supply growth to historically high levels. After all, the most basic definition of inflation is when too much money chases too few goods. With the proverbial faucet now turned off and demand slowing, we believe that inflation is set to roll over in the coming months.
Sources: Wall Street Journal, Bureau of Labor Statistics, Federal Reserve
Our fourth quarter economic strategy title is Bad News is Good News. The explanation for this counterintuitive title is that for inflation to settle in a timely manner, we need the economy to weaken. As such, at this juncture, gloomy economic data will be perceived as GOOD news, whereas in “normal” times, poor economic data is truly bad news. With that in mind, Friday’s employment report was stronger than many hoped. With revisions to previous months, the economy added 290,000 jobs in October, and while this is a large number, it is also the slowest increase we’ve seen so far this year. In short, the labor market is slowing, but not by much … yet. The unemployment rate ticked up to a still historically low 3.7% level.
In other news, China indicated a softening stance toward its zero-COVID policy. This change sent international and especially emerging markets higher and the U.S. dollar lower to close the week.
Takeaways for the Week
The Federal Reserve increased interest rates by 0.75% this week, bringing cumulative 2022 tightening to 4.0%
It is our view that the Fed is nearing the end of its tightening campaign, and evidence is building that inflation is set to decelerate meaningfully in 2023
Market participants interpret soft economic data as good news because we need to see a slowing in demand for inflation to fall