The Fed is being “Real”ly Aggressive Trying to Catch-up
Stock markets moved sharply higher into mid-August on hope for a shift toward an easier Fed in the 4th quarter and in 2023. Real interest rates were falling into Chairmen Powell’s speech in late August, having peaked on June 15th. The markets had interpreted Powell’s July comments to signal the possibility of a downshift in the pace of rate hikes. Jerome Powell’s 8-minute speech at Jackson Hole on Friday, August 26th threw cold water on that. Since then, virtually every asset market in the world has moved lower on a price basis. Stocks lower, Bond prices lower. Commodity prices? Lower.
I am Chris Perras with Oak Harvest Financial in Houston, and welcome to our weekly stock talk podcast, keeping you connected to your money. Before we get into this week’s topic, “The Fed plays catchup, do they want to break something?”
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Over the last three weeks, Jerome Powell and other Fed officials have reiterated that the central bank’s commitment to fight inflation is its top priority. It’s top priority over economic growth. The Fed has already raised rates twice by 75 basis points, and by the time this episode is published, a third consecutive 75 basis point increase will likely have been minted at the Fed’s September 20-21 meeting.
While Powell has repeatedly said that “the Fed and its committee is data dependent,” the government data they review continues to show elevated and stubborn inflation. The Fed generally relies on data collected mainly by the bureau of labor and statistics, which has historically lagged behind what’s going on in the real-time economy by months, both on the way up and way down. The release of August CPI data on September 13th exceeded analysts’ expectations and set off a cascade down in stocks and up in Fed rate expectations.
The Dow Jones Industrial Average fell over 1275 points, almost -4%; The S&P 500 dropped over -4.25%, and the tech-heavy Nasdaq sank the most, over -5.15% on the day post-release. The sell-off was especially painful in high-growth areas of the market as their terminal values are most affected by changes in interest rates.
The August consumer price index showed headline inflation rising 0.1% month over month, even with falling gasoline and oil prices. Core inflation rose 0.6% month over month. On a year-over-year basis, inflation was 8.3%.
Opposite this government data, the real-time data is saying the Fed is already getting some of the results they are seeking. Money supply growth has tanked over the last nine months after rising exponentially post-pandemic. Lower M2 money supply growth usually leads inflation by 9 to 12 months. The economy has materially slowed in 2022. Housing demand is falling off rapidly.
The labor market slowdown is underway as companies re-evaluate hiring. The jobs market is cooling with a rash of summer layoff announcements ranging from technology companies like Twilio, to FedEx, to auto manufacturers such as Ford. Layoffs are not inflationary for wages.
So, if things are heading in the Fed’s direction? What is the Fed looking at? Why are they so hawkish and wanting to raise short-term interest rates so fast after spending a decade plus worried that inflation was too low or delaying raising rates so long in 2021 when the economy was better? The Fed is afraid that inflation will become hard-wired in the economy, much as it was in the 1970s.
The two components of inflation the Fed is focused on that were a major driver of inflation in August were shelter costs and wages. Shelter costs rose 0.7% for the month. The Fed can’t do much about housing costs outside of raising interest rates which zaps mortgage demand. 6-6.25% mortgage rates are already wrecking first-time home demand from Millennials. Unfortunately, shelter costs are the most lagging variable in the CPI basket. The shelter index in the CPI basket lags the housing price development by up to 18 months. So, if house prices drop today, it will take more than a year for the CPI methodology to factor this in.
Historically, both shelter and wages are lagging inflation indicators, not leading. Why are shelter and labor costs usually lagging? They are slow to start to move up but also late to peak and decline, largely because they are not priced in real-time. People rent an apartment every year or two. Most people don’t buy a house often so the pricing there is hardly real-time and efficient.
Commodities, while not a large component of inflation readings in service economies such as America, tend to be leading indicators of future inflation. But for now, the Fed is discounting the collapse in commodities. Lumber has collapsed. Oil and gasoline are down materially off the summer highs. Early in 2022, oil pricing was up 100% year to year. Right now? It stands up about 30% year to year. Below $85/bbl in the 4th quarter of this year? Oil will be down year to year.
Many other commodities are already showing negative year-to-year comparisons. Lumber and copper, big commodity construction inputs, are down year-to-year. Copper is down 20% year-to-year. Hot rolled steel is down 60% from last summer’s demand spike with supply constraints. In fact, it’s back to 2018 levels already. Take a look at the chart.
The Fed is concerned about a tight labor market. A tight labor market which has been made worse by both the covid epidemic and an acceleration in early retirees in the last 3-5 years. The concern is that higher wage growth may make it hard for the Fed to bring down inflation.
But viewers, listeners, even there, they are getting their wish. Maybe not as fast as they want or the market thinks, but it’s happening. You can see it in the labor participation rate increasing by .3% in August to 62.4%. That still sits below its pre-covid 63.4% level but up from its Covid pandemic lows of barely 60%. And better yet, it’s headed in the right direction, up and to the right. This, over time, should help the Fed lessen their concerns over wages as more bodies participate and want to work in the workforce, just as job openings start to fall. Well, this dynamic leads to what? It historically leads to slower wage and benefit growth as employers regain negotiating leverage over new and existing employees.
Given that we are recording this pre-Fed meeting, I will assume the Fed raised rates by 75 basis points earlier in the week. Viewers, Listeners, that would be the third time this year. Over the previous 30 years, the Fed only raised rates by ¾ of a percent one other time. When was that? The last time the US Federal Reserve raised interest rates by 75 basis points, like now, a Democratic president was in the second year of his term, President Clinton. In November of 1994, Alan Greenspan announced a rate hike from 4.75 to 5.5%. Recall, much like this year, he had started raising rates earlier in 1994 when rates were 3%.
Way back then, the stock market had enjoyed a couple of good years in 1992 and 93, but it had peaked early in 1994, with Greenspan beginning to tighten rates. By the time Greenspan raised rates by 75 basis points in late November, the stock market had already been declining for about ten months returning it to where it was a year and a half earlier. The Fed raised interest rates from 3% to 6% from February 1994 to February 1995, including the November 75bps raise.
Take a look at the chart of the S&P500 in 1994. The circles are the beginning of the Fed tightening cycle, and the one in November was Greenspan’s 75bps increase. As one can see by the chart, the stock market was already heading up and to the right before Greenspan “pivoted” to the notion of possibly cutting rates in the second half of 1995. The markets were most interested in the rate of change in monetary policy.
So, the current Fed is taking the current inflation problem deathly seriously with these 75bps rate hikes. Why? It wants to make sure inflation expectations don’t become unanchored. What’s unanchored mean in layman’s terms? It means that the Fed doesn’t want consumers or businesses to expect prices to rise in the future.
If consumers expect prices to continue to move higher, then they might change behaviors, and inflation then becomes a self-fulfilling problem. If you are afraid prices will go up next week, you buy things in advance, stockpile, and hoard. It’s the opposite issue of deflation which is where people put off buying because they feel they will get a better deal by waiting a week or two.
There are a few ways to track inflation expectations. People conduct surveys of consumers and businesses. Those surveys have been heading down. Or you can look at real-time market-related data like we’ve discussed before. Right now, inflation expectations are well anchored across all time frames from 2 to 30 years. After spiking earlier in the year, the most volatile and near-term 2-year breakeven inflation rate has fallen back to levels seen earlier in the last decade. Take a look at the chart. It got as high as 5% early in the year, but it’s now sitting between 2.15% and 2.5%. That’s approaching the Fed’s stated inflation goal of 2%.
The reason that almost all investment markets have been on edge since Powell’s Jackson hole speech is that while the real-time markets see inflation fears and risks subsiding, asset investors are afraid that either the Fed doesn’t see the same thing or they don’t care and are set on a path of causing a recession to meet their inflation-fighting goals. As we have discussed a few times this year, the main cause for the broad downturn across all assets, including commodities, is the market’s expectation of higher real interest rate yields, the second component of interest rates.
The Main Takeaway:
Does the Fed want to throw our economy into a recession to tame inflation? Inflation that, by all accounts, they created a lot of by staying too easy with their own monetary policy too long so as not to hurt workers. And the parts of inflation they don’t control, like commodities and energy prices which are already falling fast out of their control? I don’t know. That seems draconian to me.
What I do believe is that as soon as the markets feel that the Fed sees the pace of inflation slowing, whether that’s in the real-time data series we watch or the lagging government BLS data, and the pace of their rate increases begins to slow, it will likely be reflected almost immediately in a peaking of real interest rates across the interest rate maturity curve.
This will likely lead to a collective relief exhale by investors across stocks, bonds, commodities, and real estate and a retreat in market volatility around almost all asset classes. Much as we saw from mid-June through Mid-August, a collective exhale would likely cause a collapsing of future volatility expectations, calmer markets, and a significant upward rally in stocks.
It’s been a sloppy, choppy, rotational mess this year and a difficult environment for the stock market as the market wrestles with how slow the economy will get as the Fed continues along its 4th quarter rate increases. The good news is that we don’t believe the Fed needs to actually “pivot” to lower rates to get the markets moving higher once again. We are currently of the belief that given the employment picture and slow growth we are in, the market would exhale significantly with just a general roadmap of slower interest rate increases over the coming six months instead of more 75 basis point increases on the table.
The real-time data behind the scenes say that the Fed is succeeding in lowering inflation. Investors want to know that the Fed sees it and believes it too and is willing to take their foot off the gas of monetary policy tightening as inflation slows.
If the ongoing market volatility is making you feel uneasy, give us a call, and schedule a meeting with an Oak Harvest advisor. Our team does have insurance-based tools that do not have the volatility of public markets. However, we remind you that these investments may also have lower long-term expected returns.
At Oak harvest, we think our clients are best served by us helping them plan for their future needs, instead of focusing on the past. The future and stock markets are always uncertain and that is why our retirement planning teams plan for your retirement needs first, and your greed’s second.
Give us a call to speak to an advisor and let us help you craft a financial plan that helps you meet your retirement goals. Call us here at (877) 896-0040 and schedule an advisor consultation. We are here to help you on your financial journey into and through your retirement years.
CFA®, CLU®, ChFC®
Chief Investment Officer, Financial Advisor
Chris is a seasoned investment professional with over 25 years of experience working with some of the most successful money management firms in the world. Chris has made it a point in his career to adapt as the market landscape changes, seeking to utilize the appropriate investment strategy for a given market environment. His transition from managing billions of dollars at the institutional level to helping individuals and families retire is guided by a desire to see first-hand the impact he is making in the lives of clients at Oak Harvest.