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Where Will the Fed Drive the Economy Next?

Last update on: Nov 24 2019

The markets now seem to realize what the Fed has been up to, but the markets probably still are behind the curve.

Investors as a group made two of their recurring mistakes during most of 2018. They projected that the recent past would continue indefinitely, and they focused on short-term news, or noise, instead of the factors that really matter to the markets.

Investors only began to realize their errors in the last few months. That increased volatility and caused prices to adjust. The strongest driver of markets and the economy is monetary policy. The Federal Reserve has been tightening policy since 2015 and accelerated the tightening in 2017 and 2018. Because monetary policy’s effects occur with lags, investors ignored the likely effects and pushed stocks to record highs.

Emerging markets and economies are affected by Fed policy changes first, so emerging market investments and economies began tumbling in early 2018 while the U.S. economy and stocks chugged higher.

In another early effect, U.S. interest rates rose rapidly during 2018. Market rates rose higher than the short-term rates the Fed controls. The interest-rate sensitive sectors of the U.S. economy also began to show the effects of tighter money in early 2018.

Housing peaked very early and contracted most of the year. Home construction stocks were down about 30% for 2018.  Auto sales slowed. There now are signs slower growth is spreading. Rapid earnings growth has been a major support of U.S. stock prices, but earnings growth is facing a number of head-winds.

Higher interest rates, the strong dollar and tariffs all increase the cost of doing business. Because of the strong labor market, many businesses complain their biggest problem is finding qualified employees for job openings. That’s causing wages to increase. While moderate by historic measures, wage growth is substantially higher than only a couple of years ago, and it could increase.

The 2017 tax cuts helped earnings growth, but the benefits of the tax cuts were a one-time boost, and that boost is starting to fade. Dividend increases and stock buy backs have been a major support of stock prices and earnings growth. These financial engineering measures also are likely to fade as interest rates increase (discouraging borrowing to fund buy backs) and the cash boost from the tax cuts fades.

Markets now are realizing the significance of the Fed’s tighter policy. That’s why stock prices began falling in late September. Interest rates also hit a short-term peak, indicating investors expect inflation to fall and growth to slow. The effects of tighter money are only beginning to affect the economy. Even if the Fed stops tightening soon, the economy will continue to feel the effects of the tightening that’s already in the pipeline.

But the Fed is likely to continue to tighten policy. While it might increase interest rates at a slower rate than it indicated a few months ago, the rate increases will continue as long as the economy, and especially the labor market, is fairly strong.

In addition to raising rates, the Fed is reducing its balance sheet by not replacing bonds that mature. That has been a major force behind rising interest rates and will continue to hurt the economy and stock markets.

Investment markets generally rose faster than the economy when the Fed was expanding the money supply. So, investments are likely to feel the pain of the tightening more than the economy.

None of my early warning indicators of a recession is near indicating a problem. But rising interest rates, the headwinds to earnings growth and other factors indicate stocks and many other investments are likely to suffer for a while.

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