Higher Rates to the Rescue

by Shawn Narancich, CFA
Executive Vice President
Equity Research and Portfolio Management

Tightening the Screws

With second quarter earnings season complete, a relatively quiet week of company specific news was supplanted by central bank action in the European Union and Canada, with both raising their short-term interest rates by three-quarters of a percentage point. The European Central Bank (ECB) has now lifted rates off the zero bound, to 0.75%, but is behind both the U.S. Federal Reserve and the Bank of Canada in the amount of tightening already implemented. In addition to tight labor markets, the ECB’s quest to achieve price stability is complicated by the fact that it is dealing with supply-push inflation, the result of increasingly constrained shipments of natural gas from Russia. Accordingly, European natural gas and electricity prices have skyrocketed, contributing to heightened risks of recession on the Continent.  While fossil fuel prices are up in the U.S. as well, natural gas prices here are still roughly only one-tenth as high as those in Europe.

Jobs Paradox

With the demand for labor supply in the U.S. exceeding those unemployed by roughly five million, the Fed’s rate hiking campaign is largely focused on eliminating this excess labor demand.  Because monetary policy affects economic activity with a lag effect of approximately one year, the risk is that our central bank will overshoot. Higher rates may not only eliminate unfilled jobs, but also cause companies especially sensitive to interest rates – in industries such as housing and capital goods -- to cut existing jobs. In the wake of last week’s employment report that showed moderating growth, weekly jobless claims declined this week, undershooting expectations. Typically, this more mundane weekly data point would not draw much attention, but with the Federal Reserve set to meet again the week after next, the Fed likely views the combination of continued healthy job growth and lower jobless claims as fresh evidence that the labor market remains too hot.  In other words, what is normally viewed as “good” is now likely viewed as bad news by our central bank.

All Eyes on the Fed

Even more importantly, next week brings the monthly Consumer Price Index (CPI) report. Expectations are for inflation in August to have moderated from 8.5% to 8.1%. In this case, declining inflation will be viewed as good news by both the Federal Reserve and investors. While the Fed still has a long way to go in bringing inflation down to its 2% target, we believe the worst of inflation is behind us. Anecdotal evidence includes price cuts on new and existing homes, declining ocean and trucking freight rates, lower oil prices and recently declining used car prices. With oil prices having dipped into the $80 per-barrel range, the price of gasoline is down, to the extent that this one input to CPI should reduce the headline inflation rate by roughly half a percentage point from July levels.

Even though the Fed focuses on the consumption price deflator to measure inflation, next week’s CPI report will be a key directional indicator. For now, central bank chair Jerome Powell’s comments at a Cato Institute gathering this week gave investors no reason to believe it will moderate the size of its next interest rate hike on September 21. At present, interest rate futures indicate a 90% chance that the Fed will match the rate hikes of the ECB and Canadian central banks by raising the federal funds rate by three-quarters of a percentage point, to a range of 3.00% - 3.25%.

Takeaways for the Week

  • Stocks rebounded 3.7% on accumulating evidence of declining inflation

  • All eyes are on the Fed ahead of its rate setting meeting later this month

Disclosures