The Fed Fights The Fed—restrictive Fed Proxy Funds Rate While Financial Markets Fight The Fed, At The Same Time, The Fed Fights Itself With Both Restrictive Fed Proxy Rates And Excess Bank Deposits Resulting From Its Quantitative Easing During The Pandemic (Qe.) Currently, Financial Markets Look For The Fed To Raise Fed Funds Rate To Close To 5 1/2 Percent From The Current 4.50-4.75%--in Three Steps. At The Same Time, Many Economists Consider The Current Fed Funds Rate Already Too Restrictive. The San Francisco’s Proxy Rate Shows Just That (See Figure 1.) The Proxy Funds Rate Indicates What Federal Funds Rate Might Typically Be Associated With If Driven Solely By The Funds Rate. After Its March Meeting, The Fed’s Governors And Reserve Bank Presidents Will Provide Further Guidance When They Update Their Quarterly Funds Rate Projections As Well As For Other Economic And Financial Variables.
Proxy Funds Rate And Effective Federal Funds Rates--restrictive
Source: Federal Reserve Bank Of San Francisco
After the pandemic, the Fed increased its balance sheet from roughly $5 trillion to nearly $9 trillion. As a result and despite the Fed’s current quantitative tightening policies, depository banks currently maintain reserves nearly double that before the pandemic (see Figure 2.) Awash in reserves, banks do not need to raise rates to attract deposits. In further support, The Financial Conditions Index from the Chicago Fed shows continued loosening of financial conditions. Battling excess QE liquidity in order to slow the economy, the Fed may raise funds rate to levels higher then financial markets currently expect. (Note: Figure 2, also, clearly shows the shifting of Fed policy for managing the fed funds rate from the corridor-type management system used before the Great Financial Crisis (2008) and taught in Economics 101 to Quantitative Easing (QE) which both makes Large Scale Asset purchases from the banks and pays them interest on excess reserves.)
Reserves Of Depository Institutions—QE Overhang
“Base Effects”--inflation Y/y May Receed In The Spring Recently released PCE Price Index measurements for January showed inflation broadly increased (see Figure 3.) However, year over year inflation trends should improve come the Spring due to the so called “Base Effects.” This results when comparing this year’s prices against last year’s spring inflation bump due, in part, to the start of the Ukraine war. In addition, declining shelter prices should also begin to produce a moderating effect on the inflation indices (see Figure 4.) The “Base Effects” will likely lead observers to pay more attention to sequential monthly measurements, rather than y/y results, to determine progress in the inflation fight.
Personal Consumption Expenditures (Pce) Price Index-median % Change Past Month
% Change past 12 Months
Source: Federal Reserve Bank of Cleveland
Selected Market-rate Rents and PCE Housing Services Price Index
Source: Federal Reserve
Labor Intense Core Services Make Up Roughly Half Of The Personal Consumption Expenditures (Pce) Price Index. Wages Help Drive Services Pricing. Therefore, Key For The Fed To Reach Its 2 Percent Inflation Goal Will Be Reducing Wage Cost Pressures For Core Services. For The December Quarter, The Atlanta Fed’s Wage Cost Tracker Showed An Average Annual Service Wage Increase Of About 6% (See Figure 5.) To Reach Its Inflation Goals The Fed Would Need To See Service Wage Growth Cut In Half Or To 3-3.5 Percent. New York Fed Research Shows That Before The Pandemic And In A Period Of Low Inflation, Wage Increases And Its Persistent Component Ranged Between +3.2 And +3.5 Percent (See Figure 6.) In 2021, As A Result Of The Pandemic, Wage Increases Then Nearly Doubled. While Wage Trends Seem To Be Peaking, The Persistent Component Suggests Wages Will Likely Remain Higher For Some Time Compared To Before The Pandemic. Unless Service Wage Gains Slow Considerably, The Fed Will Likely Be Forced To Increase The Funds Rate At Least Two-three Times Beyond Its February Increase.
Wage Growth Tracker--Services
(3-month moving avg. of median wage growth, hourly data) Source: Federal Reserve Bank Of Atlanta, Current Population Survey, Bureau Of Labor Statistics
Wage Growth And Its Persistent Component
Source: Federal Reserve Bank of New York
Baby Boomers Retiring Removes Key Job Skills And Knowledge— Replacing May Take Time And Impact Productivity—automation Technologies Part Of The Solution
The Congressional Budget Office projects the labor force growth this decade (+0.4%) will be the slowest in seventy years (see Figure 7.} With that, wage cost pressures will likely remain sticky and persistent over this decade. The sizeable Baby-Boomer cohort made a major impact on varying segments of the economy at each stage of the boomers’ life cycle. The fastest average annual U.S. labor force growth (+2.5%) occurred when the Baby Boomers entered the work force –1974-81 (see Figure 7.) Just the opposite effect will now be felt with their retirement throughout this decade (see Figure 8.) With their departure, key job skills will be lost and replacing them may initially take time and penalize productivity. To compensate for slow work force growth and lost work skills, U.S. corporations will ultimately need to increase capital spending on, but not limited to, automation and information technologies.
CBO Annual Growth Projections—Potential GDP, Labor Force, and Productivity (% Annual Change)
Source: Congressional Budget Office
U.S. Change in Share of Adult Population (16 yrs +) %Points
(From 2019 average to 12/22) Source: Economist
Retiring Baby Boomers will bring pressures on the federal budget with increased spending on Social Security and Medicare. The result will boost mandatory spending as a percent of GDP while discretionary spending, such as defense, suffers on a relative basis (see Figure 9.) After the next presidential election, these spending pressures will likely lead to both higher personal, corporate, and FICA taxes. Hopefully, some rollback of federal spending growth will also result. From an investment point-of-view, among the favorable investment impacts from the aging population will be on the growth of healthcare and medical spending as well as spending on travel and leisure time pursuits. Finally, retirees will be reducing their investments, over time, to fund their retirement. Whether those withdrawals will negatively affect financial markets or not will ultimately depend on the broader economic and financial environment
Federal Government Spending Outlays by Category
(% of GDP) Source: Congressional Budget Office
Timing Of Short-term Peak Rates Key To Financial Markets Milton Friedman Theorized That Monetary Policy Impacts Demand And Inflation With “long And Variable Lags.” That Theory Will Now Be Tested Over The Next 12 Months As The Economy Meets The Reality Of Recent And Future Fed Rate Increases. Based On Market History, Financial Markets Will Not Likely Bottom Until After Short-rates Peak. Moreover, In The Last Five Interest Rate Cycles, Once The Fed Reached Its Peak Rate, It Held That Rate For An Average Of 11 Months. Financial Markets And The Fed Will Likely Keep Bumping Heads. Time Will Tell Whether The Old Adage “don’t Fight The Fed” Ultimately Wins Out In The End.
Equities— the Period Post-covid And, Unfortunately, The Continuing War In Ukraine Will Create Future Economic And Investment Opportunities That Could Importantly Differ From Those Experienced During The Last Decade. Assuming The End Of Zero Interest Rates, Real Earnings Growth Will Prove More Key Than In The Past To Equity Returns. With The Likelihood Of An Improving 2024 Economic Outlook, Long-term Investors Should Consider Taking Advantage Of Currently Attractive Valuations For Those Quality Investments That Can Produce Real Earnings Growth With Strong Balance Sheets. They Should Focus On Those Sectors That Will Meet The Demands Arising From These Changes Such As Automation Technologies, Healthcare And Medical Services, And Agricultural Services And Equipment.
Ukraine—increased Potential For Volatile Market Reactions-- Russia Now, More Than Ever, Sees Itself Fighting A Proxy War With The West. The Top Of The Kremlin May React By Bringing Greater Intensity To The Expected Russian Spring And Summer Offensives. Headline Events From Russian And Ukrainian Battles Will Likely Result In Both Increased But Unpredictable Volatility For Both Financial And Commodity Markets. No Doubt, Food Inflation Will Continue To Be Pressured From The Impact Of This War. Longer-term, This War Will Lead To Increased Spending For Armaments And Cyber Security By Both This Country And Europe. To The Europeans, One Expert Observed, “war Is A Theoretical Thing. So We Have Theoretical Tanks.”
Fixed Income—“income” In Fixed Income Now Carries Real Meaning. With That, Employing Cash, Using Short-duration Treasury Notes And Bills, Should Provide Investors With Both Real Income As Well As A Counter Against The High Level Of Economic And Financial Market Uncertainties. As 2023 Progresses, Lengthening Bond Duration, By Degree, Will Likely Prove Increasingly Attractive When And If Inflation Declines. Alternative Investments Can Also Be Used For That Portion Of The Portfolio Historically Committed To Fixed Income; Alternatives Tend To Be Less Correlated With Stocks And Bonds. That Diversification Will Prove Particularly Valuable With Today’s High Level Of Economic And Investment Uncertainties.
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