Chair Powell—Sensitive to Fed’s Errors in the 70’s – Avoid Prematurely Loosening Fed Policies

Our past Commentaries referred to the Fed’s failed stop-and-go interest rate policies during the inflationary seventies (See Figure 1). That past troubled experience showed how hard it proved to be to finally pull down sticky inflation. That prior track record could lead to similar errors if today’s Fed prematurely loosens its policies at early signs of either the economy or inflation slowing. Therefore, the Fed will likely prove sensitive to the 70’s performance when considering its future rate strategies. Clearly, the tone Chair Powell took in his brief, but clear speech at the Jackson Hole Symposium indicated sensitivity to those concerns. His message stated that the Fed would “require a restrictive policy stance for some time” in order to reach its two percent inflation goal. At year-end, the funds rate, based on the Fed’s expectations, will likely reach 3¼–3 ½%. At that time, the Fed expects to pause to examine the impact of their current policies based on incoming data and the evolving outlook. In doing so, the Fed would look to determine how anchored consumer and business inflation expectations seem to be. In addition, they would likely examine whether the breadth of inflation narrowed as measured, for example, by the Cleveland Fed’s Median and Trimmed Median CPI. At that point, in our view, the 3¼–3 ½% funds rate will neither prove neutral nor restrictive. Therefore, the likely year-end funds rate will not prove sufficiently restrictive, over time, to return inflation to the Fed’s 2 percent goal. If that conclusion proves correct, after some pause and absent a major economic decline, the Fed will likely raise its funds rate, in steps, to reach approximately four percent by year-end 2023.

Figure 1

Fed’s 1970’s Stop-and-Go Attempts to Bring Down Inflation

Source: The Wall Street Journal, Labor Department, Federal Reserve

Treasury Actions May Reduce Near-Term Concerns of QT Impact

September marks the month when the Fed fully implements its Quantitative Tightening (QT) policy. It will do so by doubling to $95 billion the monthly rate at which the Fed reduces its balance sheet. By shrinking its balance sheet, the Fed will likely reduce financial market liquidity. To moderate such potential disruptions from QT, Treasury will likely issue bills to repurchase already outstanding coupon debt. Treasury’s actions would improve the banking systems’ overall liquidity by increasing their reserves but would not affect the size of the Fed’s balance sheet. Issuing bills to replace coupon debt would also help improve the current poor liquidity in the Treasury market and moderate its interest rate sensitivity (see Figure 2). Actions by the Treasury should reduce near-term concerns as to the impact of QT. Over time, however, QT will likely remove financial market liquidity when compared to the flows generated by Quantitative Easing (QE) during the last decade.

Figure 2

Treasury Market Depth 1-Month Moving Average

Source: The Marginal Buyer

CPI Core Index More Volatile than PCE Core Price Index

To evaluate its efforts to control inflation, the Fed focuses on core inflation—specifically core PCE price index inflation—to avoid the unpredictable ups and downs of energy and food prices. How government agencies gather price data and weigh various components—shelter and healthcare as examples--creates more volatility for the CPI when compared to the PCE price index. Figure 3 shows that pattern with PCE core inflation currently lower than the CPI.

Figure 3

Personal Consumption Expenditures Price Index (PCE) vs Consumer Price Index (CPI)

Source: FactSet

Goods Inflation Likely Peaked — Services Inflation Moving Higher — Labor Costs Increases Driving Service Sector Pricing Higher

Absent the Federal Government’s series of stimulus programs, consumers returned to more normal buying patterns this year and shifted more of their spending from goods to services. The result: goods inflation declined from its peak — admittedly still high. In comparison, service sector inflation still keeps moving higher (see Figure 4). With goods inflation trending down, the inflation focus will turn to two sectors continuing to experience rising prices — services and shelter. Labor-intensive service prices reflect increasing wage costs (see Figure 5). Business demand for workers continues to substantially exceed their availability (see Figure 6). Recent research from the New York Fed points to a strong relationship between labor market tightness and compensation growth for both manufacturing and services sectors (see Figure 7). N. Y. Fed researchers used the vacancy-to-hire ratio as a proxy for extreme labor market tightness.

Figure 4

Consumer Core Price Inflation — 12 Month % Change — Annual Rate

Source: The Wall Street Journal

Figure 5

Service Inflation Compared to Labor Inflation

Source: Bureau of Labor Statistics, Macrobond, ANZ Research, Daily Shot

Figure 6

Labor Market Flows

Figure 7

Compensation Growth is Correlated with Labor Market Tightness

Source: U.S. Bureau of Labor Statistics, Federal Reserve Bank of New York

U.S. Slow Workforce Growth This Decade – Labor Intensive Service Sectors Inflation May Prove Sticky — Forces Higher Levels of Unemployment to Lower Service Inflation

Tight labor markets and the resulting wage pressures will likely exist for most of this decade as the U.S. faces the slowest workforce growth in fifty years (see Figure 8). With that workforce outlook, service sector inflation may prove sticky and more difficult for the Fed to pull down. To attempt to do so, the Fed will need to weaken the economy sufficiently to reduce excess job openings. That reduction seems to be beginning as job openings fell by over one million – so far (see Figure 6 — above). Controversy exists among economists as to whether the Fed’s tightening policies can balance further job opening reductions while still keeping enough jobs available to satisfy demand from those laid off. If that can be achieved, then the unemployment rate may not rise much higher than the Fed’s forecast of 4.1% in 2023 compared to the current 3.5% rate. If that can be achieved, then the modest odds for an economic soft-landing increase. However, not all economists agree with that employment outcome. Instead, many economists project that it will take roughly an unemployment rate of 5 percent or higher to bring down wage costs and thereby service inflation. If that proves the case, then an economic decline seems more likely.

Figure 8

U.S. Labor Force Growth by Decades

Source: Truist Advisory Services, Reuters Graphics

Shelter Inflation in the Price Indices Lags Marginal Real World Shelter Price Changes – Shelter Price Index Increases Likely to Continue into the First Half of 2023

How fast shelter inflation moderates will prove a second key to bringing core inflation down to the Fed’s 2 percent goal. Shelter costs comprise important components of both the CPI — roughly one-third – and the PCE Price Index – approximately 15%. Shelter costs tend to lag real-world prices by 12-18 months. With new home sales hitting a six-year low and existing home sales down to their lowest levels since the middle of 2020, housing prices should begin to react to weaker sales. Reflecting the lag effect, researchers at the Dallas Fed forecast shelter costs, used in both inflation indices, will still likely continue to rise into the Spring of 2023--then begin to ease to reflect moderating rent and house prices (see Figure 9).

Figure 9

Rent, Owners’ Equivalent Rent Inflation Forecasts

Source: Bureau of Economic Analysis, Zillow, Haver Analytics, Federal Reserve Bank of San Francisco

Eroding Analyst Earnings Forecasts for the Remainder of 2023

With expected economic slowing, investment analyst forecasts for second-half earnings continue to erode (See Figure 10). Among other factors, lowered earnings estimates likely reflect price discounts to clear-out excess inventories. This will be the case not only for retailers but for other sectors such as semiconductor producers. In addition, pressuring the profits of many U.S. multi-national corporations will be weakening global economies and the strong dollar. A likely European recession early next year would be a major contributor to that cloudy global picture. With roughly forty percent of their revenues generated from foreign sources, information technology companies will prove particularly vulnerable to the weakening global economic outlook.

Figure 10

S&P 500 Operating E.P.S. Quarterly Consensus Forecasts 2022

Source: Yardeni Research, I/B/E/S data by Refinitiv, Daily Shot

Investment Conclusions

QT Impact on Equities – A number of rapidly changing factors will likely make future economic and financial forces different from those experienced in the last decade. One factor included in this Commentary will be the shift from Quantitative Easing (QE) to Quantitative Tightening (QT). Absent expansive liquidity flows generated by QE, QT will likely reduce inflated valuations in the financial markets similar to what the Fed wants to achieve in the economy. In this new monetary policy regime, investors will need to give greater focus to corporate fundamentals in the absence of multiple inflation. Fundamental marks of quality companies include strong balance sheets combined with consistent earnings, free cash flow, and dividend growth. Companies that show these fundamental strengths should successfully survive the likely macroeconomic shifts and prove attractive investments.

Fixed Income and Alternatives — With aggressive actions taken by the Fed to bring down inflation, economic slowing will likely follow. A slowing economy increases the attractiveness of fixed-income securities. Shorter-duration Treasury notes should also prove effective in countering higher equity market uncertainties. As recommended in previous Commentaries, a select group of alternative investments also fits that portion of the portfolio historically committed to fixed income.

Private Equity and Venture Capital – Economic growth depends on both workforce and productivity growth. With slowing U.S. Workforce growth, increasing productivity will be key to economic expansion. Investments in venture capital and private equity should be one source of answers to both improving productivity and rewarding to investors.