The Fed Isn’t Finished
Inflation probably peaked for this cycle, but the Federal Reserve still has a lot of work to do. Investors already fooled themselves a couple of times in 2022 by concluding prematurely that the Fed was done tightening monetary policy and soon would adopt a looser one. Investors became enthusiastic again in November after the Consum- er Price Index (CPI) for October was lower than most forecasts and the 12-month rate of increase was the lowest since January 2022.
The expectation of easier mone- tary policy is premature. The steady 0.75% increases in the Fed funds rate probably will stop, but tightening will continue at a slower pace. Tightening money at a slower pace is far from the change to an easy monetary policy that’s priced into the markets. In addition to raising interest rates, the Fed is steadily draining liquidity from the markets and economy by reducing its balance sheet and the monetary base.
It continues to reduce the balance sheet significantly each month, independent of changes in interest rates. Some of the inflation in commodities and goods prices is easing because of reduced demand and improvements in supply chains. But some key forces that pushed inflation to its highest level in more than 40 years remain in place.
Inflation for services remains high, and services are about 30% of the CPI. That will continue for a while, as the labor market remains tight. Employers continue to hire and have many unfilled job openings. Compensation increases still are much higher than the multi-de- cade average. Though compensation increases lag the inflation rate, the higher incomes support spending and keep a floor on inflation. The Fed leaders say they will maintain a tight mon- etary policy until inflation nears its 2% target rate.
Most Fed members don’t want to ease too soon, because that would raise the risk of stagflation (slow growth and high inflation). In 2022 interest rates in- creased at one of the fastest paces ever. The Fed has already tightened enough to cause a recession in 2023. But because of lags between a policy change and its effects, the slowdown has only started.
The sectors that depend the most on liquidity are hurt first, including housing, technology and speculative investments (such as digital currencies). They already have been damaged. More crises and disruptions are likely.
The labor market is late to react. Un- employment often doesn’t increase until after a recession has begun. Inflation usually doesn’t turn down for good until sometime during a recession. The Fed won’t stop tightening until it sees significant changes in the labor market and inflation, though it already set the table for those changes. Investors are expecting a fast change in the Fed’s policy, but there could be a long time between the end of tightening and a shift to easy monetary policy.
Bear market bottoms in stocks typically don’t occur until the Fed switches to an easy policy and begins lowering interest rates. The real issue is how the Fed will react once economic pain spreads from a few sectors to the broader economy. Will the Fed maintain a tight monetary policy until inflation is at or near its target? Or after economic pain becomes wide- spread will the Fed switch to an easier policy when inflation still is 4% or so and risk re-triggering inflation? Historically, the Fed maintains the tight policy too long, just as it main- tained its easy policy too long in 2020 and 2021.
Most investors suffer from recency bias. They know the Fed has supported stock prices since 2009 and believe it will continue to do so. But the long-term trends that kept inflation low are over. The Fed no longer can support stocks without pushing inflation higher.
I believe policy will remain tight longer than the markets expect. There should be further downside in stocks and other risky assets unless inflation collapses quickly or the level of economic pain causes the Fed to abandon its inflation target.
