Juggling many balls in the air takes talent, but normally the stakes are low (unless you’re juggling knives or things that are on fire, of course.) But when it comes to the Federal Reserve, the economy’s fate hangs on their ability to keep all those balls off the ground and in the air. Read on for our analysis of how they’re doing these days!
Role of the Federal Reserve
The Federal Reserve is the central bank of the United States. Their job is to control the money supply in the economy by setting, and periodically adjusting, the federal funds rate, or the rate that banks use to borrow and lend to each other. In turn, the banks pass those adjusted rates on to consumers, creating an expanding or contracting loop.
When the economy is struggling, the Fed may lower interest rates to boost the economy. This makes it easier for companies to borrow money to expand operations and hiring. The consequence is higher employment rates, more consumer spending, and a bustling economy.
However, if the economy is thriving, the Fed may increase rates to make borrowing more expensive. The hope is that this puts pressure on further expansion, but there’s a potential consequence of increasing the unemployment rate.
In our current unique environment, the economy is humming along despite high-interest rates. Consumers are still spending, albeit at a slower pace, and unemployment rates are slowly rising but remain at historically low levels.
All eyes are on how the Fed will juggle the federal funds rate over the next few months.
A Dual Mandate
The Fed has a dual mandate: to achieve maximum employment while keeping prices stable by raising or lowering interest rates as they deem necessary. The challenge is that those two goals often contradict each other: it may be downright impossible to maximize employment without increasing price pressures.
Federal Reserve Chairman Jerome Powell has admitted that the central bank was caught off guard by historically high inflation that was deemed transitory. Powell blamed it on supply chain issues and a slow return of workers to the job market post-pandemic.
Market participants are starting to lose confidence in the Fed’s ability to simultaneously stabilize the economy and guide financial markets. This is evident in the market volatility that occurs around the time of Federal Open Market Committee (FOMC) meetings and Chairman Powell’s press conferences.
How It Started
In response to the COVID pandemic, the US government’s massive stimulus packages caused inflation to run hot. Throughout 2021, the Fed characterized this rampant runaway inflation as transitory. When the Fed finally realized they had dropped the ball, it was too late and inflation kept hovering around 9%. They addressed it by spiking interest rates and keeping them elevated.
How It’s Going
Since June of 2023, inflation has been hanging around at 3%, higher than the Fed’s target rate of 2%. They paused the federal funds rate at a target range of 5.25% to 5.5% in the second half of 2023. Chairman Powell has reiterated a go-slow approach to rate cuts. The economy’s resilience has officials in no rush to ease monetary policy while the economy and the job market continue to grow.
The labor market is unusually strong. The unemployment rate currently stands at 3.8% and the BLS reports that most of the job gains came from the construction, government, and healthcare sectors. A recent Job Openings and Labor Turnover Summary (JOLTS) showed there were 8.8 million job openings in February 2024. Wage gains are also above average.
As of April 15, 2024, US retail sales are at $615.86 billion, which is a 0.77% increase from the previous month and a 3.64% increase from the previous year. Advance estimates for March 2024 retail and food services sales are $709.6 billion, which is a 0.7% increase from the previous month and a 4.0% increase from March 2023. In March 2024, retail sales increased across several categories including online sales, Specialty Stores, Restaurants, and Bars.
Even so, the higher-for-longer policy has depressed disposable income: the sales of electronics, clothes, and sporting goods have all decreased by 1.2%, 1.6%, and 1.8%, respectively.
The Future of Rate Cuts
The Fed is signaling that we are nearing a long-awaited shift toward rate-cutting now that its officials believe they are close to fully taming inflation. No longer does its policy statement mention a consideration of further rate hikes.
But not just yet! The first rate cut is probably still months away. In their statement, the Fed says it wouldn’t be time to cut rates “until it has gained greater confidence that inflation is moving sustainably” to their 2% target.
Chairman Powell also indicated that faster growth could cause inflation to stall at a rate above 2%, complicating the Fed’s timetable for rate cuts. For now, with the economy performing well, the Fed isn’t in a rush to reduce borrowing costs.
What do market participants think? They are pricing a first rate cut of 25 basis points in September, followed by two more rate cuts of 25 basis points each in November and December.
Impact on Risk Assets
Past data has shown that risk assets do well when the Fed is in pause mode, as they are right now. We anticipate that risk assets will continue to do extremely well while rates remain unchanged.
Impact on Consumers
These high-interest rates are stifling the average consumer’s disposable income. Home and new car payments are unaffordable for first-time buyers. Unemployment rates are still low, meaning that most people still have jobs and can make their monthly payments. But when the layoffs begin, they accelerate very quickly and impact other areas of the economy, creating a downward spiral.
The Media’s Narrative
The media and talking heads seem convinced that the Fed is on the cusp of achieving a rare “soft landing,” in which it manages to conquer high inflation without causing a recession. Our analysis shows that this narrative is incorrect.
Our Assessment
It is obvious to us that the Fed’s analysis, models, and forecasts are flawed. Systemic issues have not been fully addressed and our analysis implies that the Fed will be proven to have dropped the ball… again. The full effect of the higher-for-longer policy has not yet been felt throughout the economy and the Fed is simply unable to anticipate the lagging impact of their tight monetary policy.
Over time, the yield curve will uninvert as market participants anticipate lower rates. The Fed will then follow suit by lowering rates aggressively. By the time they realize they failed to anticipate the lagging effects of their policy, the business cycle will have turned and they will be unable to stave off the ensuing recession.
It sure is a lot to juggle, with an entire economy at stake. We will be watching all the balls that are in play to see which ones fall to the ground, which stay in the air, and which bounce back higher than before.
