“We are navigating by the stars under cloudy skies” – Jerome Powell
In late October, I was fortunate to see Jerome Powell speak at The Economic Club of New York. Founded in 1907, The Economic Club has hosted world-renowned figures such as Winston Churchill, John F. Kennedy, and Margaret Thatcher. This particular event, featuring Chairman Powell, drew so many attendees that organizers had to move it to the Hilton in Midtown Manhattan. People were eager to hear Chairman Powell’s message, which echoed what we have heard from the Fed over the past year. The presentation reinforced a few key investment themes that may come to fruition over the next 6 to 12 months.
- Investors should not expect the Fed to significantly cut rates if the economy weakens.
During the past two financial crises – the Great Financial Crisis and Covid-19 – the Fed’s response was swift and decisive. Interest rates were cut to zero in an effort to stimulate the economy and maintain order in financial markets. Moving forward, should the economy weaken as a result of higher rates, it is unlikely that the Fed will act as quickly, as any stimulus may cause a rebound in inflationary forces. To be clear – we are not able to predict the future – but if we do have an economic downturn, it is unlikely that the Fed’s response will mirror past policy decisions in terms of magnitude. It is apparent that the Fed is more focused on reducing inflation rather than stoking the fires of economic growth.
- Expect elevated volatility in the short-term.
Since the Great Financial Crisis in 2008-2009, the Federal Reserve has become a much more transparent institution in terms of signaling to the market when it plans to change monetary policy. The theme of transparency from the Fed significantly differs from past administrations, who seemed to have changed their policies at the drop of hat, and without signaling to the market that changes were coming. While the institution itself has certainly been more transparent than past administrations, it is unlikely the Fed will let markets know they are finished with rate increases until well after the last hike. This ‘extra layer’ of uncertainty will likely cause additional volatility in the foreseeable future for both the bond and stock markets – especially if inflation figures move higher or lower in a meaningful way. Market participants should expect and plan for this excess volatility.
3. The Fed has conflicting dual mandates – low unemployment and low inflation. It is clear they are focused on the latter.
Many economists have argued that the Fed will need to induce some type of economic slowdown to get inflation under control. In fact, 100% of surveyed economists suggested that a Fed-induced recession was highly likely in 2023 as a result of higher interest rates. One year later third quarter GDP, which is a measure of economic growth, came in at 4.9%, following positive economic growth in both the first and second quarter of 2023. As for inflation, the headline CPI print was 3.7% in September 2023 vs 8.2% in September 2022. A surprisingly strong economy paired with declining, but moderating inflation should mean higher rates for longer – even if the unemployment figures begin to move slightly higher. The Fed is clear that rates will remain close to their current levels until inflation is clearly in the rear-view mirror.
Ultimately, it is an exercise in futility to predict the final outcome of the current rate hike cycle. The Fed has been able to navigate the current inflation dynamic without causing collateral damage to the economy. So far, we’ve seen inflation move lower without a dramatic increase in unemployment or a slowdown in economic growth. Hopefully, the clouds recede.