Forecasting the Fed

Don’t fight the Fed.

There are few market adages that carry more weight than this one. Over the last 15 years, the Federal Reserve has continuously stepped in to support market liquidity when the situation turned dire. They embarked on unprecedented quantitative easing experiments as a result of the great financial crisis, keeping a lid on interest rates throughout much of the 2010s. They kept the Federal Funds target rate at 0% for nearly a decade. And when COVID hit, they even went so far as to backstop corporate debt. It all added up to one of the best periods for investors we’d ever seen. Bond prices rose. Stock prices rose even more. And each selloff seemed more short-lived than the last. Being bearish for any extended period proved futile – you can’t fight the Fed.

We live in a different world, today. With inflation at 40-year highs, the Federal Reserve is hyper-focused on tightening monetary policy until demand cools and price pressures deteriorate. Don’t fight the Fed. Until Powell and Co. pivot away from their ultra-restrictive stance, it’ll pay to keep a cautious approach toward stocks.

So what – besides the latest CPI report – is the Fed watching for signs their actions are working?

The labor market, for one. The resurgence of inflation over the past two years has led to a revival of the Philips curve. The Philips curve states that inflation and unemployment are inversely related – when unemployment is low, inflation will be high. During the years preceding the pandemic, many economists gave up on the theory as a useful model for the economy, and understandably so. From 2017-2019, unemployment fell from 4.7% to a 50-year low of 3.5%, but prices showed no ill-effects.

Now that inflation has returned, though, Philips curve believers are back. Two recent Fed studies – one from San Francisco and the other from New York – showed that wages and inflation have become increasingly linked. Powell is hoping the labor market will soften even more in coming months, crimping demand and curtailing prices.

In the latest Summary of Economic Projections from the FOMC, officials saw a median year-end Federal Funds target rate of 4.4%. They expect to hike rates to 4.6% in 2023, before cutting them to 3.9% by 2024. In doing so, they anticipate joblessness will increase from July’s low of 3.5% to 4.4% next year. Never has the unemployment rate risen that much outside of full-blown economic recession. For his part, Powell has stated on multiple occasions now that pain is inevitable. While the Fed still hopes to achieve a soft landing, the odds of success are increasingly low.

What makes this potential recession different is the Fed’s inability to respond – Powell has committed to keeping rates elevated for an extended period, lest we repeat the errors of the 1970s. At his Jackson Hole speech, and again after the September FOMC meeting, he cautioned against declaring premature victory over inflation. First, they must break the grip of inflation expectations. In the meantime, don’t fight the Fed.

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