If you are perplexed trying to understand the health of the economy and the impact of two wars, a growing national debt, inflation, and interest rate policy on markets this article looks at the confluence of all these issues and what is going on in the economy and markets.
Let’s start with the Federal Reserve and Chairman Powell. During the press conference at their September meeting, Powell stated that they would be pausing rates and were perhaps close to the end of their hiking campaign. Other governors including Mary Daly, head of the San Francisco Federal Reserve Bank, also weighed in saying that long term rates of the 10 years plus US Treasury Yields would add to restricting monetary conditions and that this, in addition to interest hikes to date, might accomplish one of their core mandates in bringing core inflation down to their targeted 2% acceptable level.
A rise in bond yields may substitute for a rate hike, Fed’s Daly says.
– Bloomberg, 10/10/23
The objective of hiking rates is to tighten monetary conditions, and both depress and disincentivize economic activity, lowering consumption and demand, which in turn should lower inflation. Conversely, if the economy is in decline, the Fed can do the opposite - lower rates - to stimulate the economy by encouraging investment and incentivize capital deployment. The two activities describe one of the mainstay traditional tools that the Federal Reserve has at its disposal to both stimulate (expand credit) or slow (tighten credit) in the economy.
So, how effective have the Federal Reserve’s Rate hikes and QT (Quantitative Tightening) been?
1. The Federal Reserve's preferred inflation measure, the core personal consumption expenditures price index has fallen to an annual rate of 3.7%, down from 5.3% in February 2022. The Consumer Price Index (CPI) – as reported today, November 14th, 2023 - showed prices were flat over last month and rose 3.2% over the prior year in October, a deceleration from September's 0.4% monthly increase and 3.7% annual gain in prices. The markets responded to the news positively as it beat analyst expectations. Even though Inflation still has some way to go before it reaches the Fed’s 2% target, market analysts are no longer expecting the Fed to increase rates and are forecasting rate-cuts in 2024.
The evidence as articulated in this article does not point to that conclusion, but the Fed may have its reasons as we will elaborate further in this article to pause any further decisions on the matter for a more extended period before it takes any further action.
Even though it appears that progress is being made in the fight against inflation, it should be noted that the Fed’s preferred measure of inflation does not include “food” or “energy” prices. The more widely followed “consumer price index” – which does include food and energy prices - peaked above 9% in June of the previous year and rose by 6.7% in the 12 months to September 2023. The core CPI per data released today - November 14th 2023 - increased 0.2% and 4%, against the forecast of 0.3% and 4.1%. The 6.7% year to date CPI measure through September rings truer in most consumers’ experience, especially each time we walk out of the supermarket and gasp at what we just paid for some basic food items.
2. The other measure of the health of the economy is GDP which at 4.9% for Q2 and 5% in Q3, 2023 is hardly the sign of a contracting economy. Quite the opposite.
Irrespective of what you may read in the mainstream press, the economy is in the main doing well by every measure and inflation while lower than the year before is still relatively high and if you use the CPI measure of inflation, a long way from that Fed’s targeted 2% per annum. One must conclude that the interest-rate policy to date has had some impact but has, in large part, been ineffective to date.
It is therefore no surprise that Powell reiterated again, recently at the IMF, that theFed "is committed to achieving a stance of monetary policy that is sufficiently restrictive to bring inflation down to 2% over time; We are not confident that we have achieved such a stance. If it becomes appropriate to tighten policy further, we will not hesitate to do so."
There is no reason to be confident in the slightest even with the latest news. Rates are being held in the 5.25% to 5.5% range, but GDP remains strong, and inflation remains an issue. It is also hard, given the backdrop of strong GDP numbers, to see rent's falling anytime soon, which comprises a significant part of what has been driving overall inflation in the economy.
Some may argue that the Fed policy has been flawed from the outset, both in contributing to creating the problem of inflation to begin with and in combatting it. Trillions of dollars flowing into the economy post COVID and easy access to cheap money for years was inevitably going to have an inflationary impact. However, the price increases post COVID were in large part also caused by “supply chain” related issues, as the global industrial complex got derailed and came to a grinding halt. High demand coupled with supply shortages meant only one outcome…prices headed north…up! Not that corporations needed an excuse to raise prices, but COVID coupled with a Ukraine/Russia war created the perfect storm and rationale to raise prices and profits. The “supply chain” disruption coupled with a massive injection of stimulus and capital into the economy led to high inflation in the economy. Many supply chain issues have been resolved now and while pricing on the “supply-chain” side has come down, the consumer at the end of the line is not altogether seeing the benefit.
The resulting impact of interest rate hike policy to here, which we will look at in part two of this article (coming out in a few days), suggests the Fed may need to take more action which in turn has other implications which we will also examine.