Goldilocks vs. the Fed

A turn in the economy in early 2023 disrupted the plans of many investors and the Federal Reserve. As 2022 ended, investors were poised for inflation to hit the Fed’s 2% target without a recession and for the Fed to shift to an easy money policy by the second half of 2023.

But the economy surged to start 2023. The year began with better-than-expected data on retail sales, employment, manufacturing and more. Plus, inflation declined much less rapidly. The yield on the 10-year treasury bond peaked around 4.25% in late-October 2022, then declined to 3.40% in early February. But interest rates turned higher because of the stronger economic data in early 2023, with the yield cresting above 4% by March 7. Stock indexes also tumbled from their early February highs.

The easy fixes to inflation are over. The supply chain problems are solved or being worked around. Fiscal stimulus is out of the system, and the Fed stopped pumping additional money into the economy. China ended its dynamic zero-Covid policies and is no longer closing large swaths of its economy.

The main force pushing inflation lower now is the housing component of the Consumer Price Index (CPI), which should continue declining because of the way housing inflation is computed in the CPI. But downward pressure on inflation should be offset by other factors. Instead of continuing to tumble, inflation is likely to settle on a fairly high plateau. Two major factors support inflation and make it sticky. The stock market rally since its 2022 low makes people feel wealthier, increasing their propensity to spend.

That’s the wealth effect the Fed facilitated during the financial crisis. The spending supports increased prices for goods and services. Each sign that inflation might decline makes investors believe the Fed soon will expand the money supply. They become optimistic and push stock prices higher. High stock prices fuel spending and keep inflation from falling. The labor market is another factor supporting inflation, as I’ve been stressing for months. The tight labor market favors workers.

There are many unfilled job openings. Unemployment is low. Wage growth is well above its levels of the past 10 or 15 years and above the level that would lead to 2% inflation. Higher wages and confident workers support spending on goods and services, and that supports price increases. Fed officials know about these factors supporting inflation and say they are committed to reducing inflation.

They know inflation is unlikely to reach their target unless stock prices decline, and economic growth is weaker. That’s why I expect interest rates to increase above the levels recently anticipated in the futures markets, and I believe the Fed will keep rates high for longer than the markets expect, barring a financial crisis.

Higher interest rates are bearish for most asset prices, especially financial assets such as stocks. Stock investors also should be concerned about profit margins and earnings. Slower economic growth should lead to further declines in the revenues and earnings of most publicly traded companies. Also likely to cause profit margins to shrink are higher wages, lower productivity, the end of fiscal stimulus, higher commodity prices, reduced global trade and other factors.

Recent stock market prices don’t reflect these factors and the potential for sustained lower revenues, earnings and profit margins. As some analysts say, the market is priced for perfection and does not have a margin of safety that allows for sticky inflation, higher interest rates and slower growth. Stocks still sell at fairly high valuations that are appropriate for an economic environment with less uncertainty and fewer risks than we have today.

That’s why I’m not recommending we take on more risk yet. The 5% yields recently paid on safe, liquid investments are very attractive.