Navigating Fed Policy Challenges During Persistent Inflation

2H23, from an asset price standpoint, is likely to be more challenging than 1H23, but not for the reason MS cites. A few observations: a) The primary reason, IMO, the first half was quite good for asset prices was the market expectations and thus pricing of a recession. This was reflected in the investor sentiment, positioning and the yield curve. That, however, has been priced out. That is not to say that earnings are going too be under tremendous pressure. Nominal growth remains quite robust and earnings are likely to be fine even if they are not spectacular. Focusing on poor earnings to foretell the direction of the markets hasn't and is unlikely to work out given the high nominal growth trend. b) The real challenge for the markets is more likely to come from the potential repricing in the long end of the curve. Given the incoming data, it is almost a certainty that the Fed goes in July and probably goes one more time, more likely in November. While that drives the front end of the curve, the real risk is really in the long end of the curve. Given the current level of core inflation -- which is slowing but at a very slow pace, in all likelihood, the Fed may stop raising rates at some point this year. But that does not mean that the Fed is relenting on its policy path anytime soon. It may have to hold the high level of FF rate for a longer period of time. c) The long end of the bond markets have been supported by well anchored policy rates and very modest real rates. If the Fed holds FF rates at a high level for a long time, it is entirely conceivable that even in an environment of anchored inflation expectations, real rates rise somewhat, pressuring the nominal curve. That is not an environment for meaningful appreciation in asset prices. d)The most likely outcome IMO is that equity markets give up some of their near term gains but do not correct meaningfully. The real pain, albeit manageable, is more likely to occur in the bond market, I think. e) The real surprise of the markets is likely to come about if the economy reaccelerates. While the manufacturing economy has slowed a lot, housing, construction, investment, employment are all showing unusual strength. If manufacturing comes out of its funk, perhaps due to the unwinding of the bullwhip effect, it will be a big challenge for the Fed, the long end of the bond market and consequently asset prices. The bottom line is that despite the fastest increase in policy rates, the economy is showing unusual strength making asset prices more vulnerable as both sentiment and positioning has changed. Equity prices probably don't correct much, but unlikely to go up meaningfully. However, if the economic reacceleration manifests itself, the environment may change meaningfully due to repricing of the bond market. MS prediction may actually come about, but not for the reason they cite.

The Fed did not increase rates. Is it important? The real question should be how to position financially based on Fed monetary policy. Today, we held an interesting discussion with our portfolio managers - Juan Xavier Sanchez, CFA, and Jose Luis Cova. I will share some highlights, explain how we position investment portfolios, and advise clients.   Our analysis suggests the Fed is looking at core inflation and wage growth as the key metrics for their approach to rate increases and liquidity in the economy. Why? Core inflation includes shelter (real estate), medical expenses, and transportation, which tend to be ‘sticky’ in nature, meaning they take longer to change. Food and energy are excluded because of their volatility and cyclical nature. Wage growth spiked during the last two years, fueled by low unemployment. A strong labor market is a good sign of a healthy economy, but too much growth can cause higher inflation. According to the Federal Reserve Bank of Atlanta survey, wage growth spiked in the summer last year by about 6.7% and decreased to about 5.3% this summer. How are we positioning investment portfolios? In equities, we favor companies with strong balance sheets and cash flows that help them avoid financing at high rates. In terms of fixed income, keep a relatively short duration. We are not going long because the market isn’t compensating enough for the risk; interest rate and credit risk are involved. Alternatives have been a key focus for our portfolios. We have been finding great opportunities in the private credit space, including loans to corporations and real estate. The yields are attractive, and the volatility is much lower than in public markets. How are we advising regarding family finances? With high rates, it makes sense to be a lender, not a borrower. It used to be the other way around for many years. It might sound simple; the problem is that these changes take time, and personal issues are involved. For example, families looking to buy a home with a mortgage today must spend much more. Today, it seems better to put more money down and less debt than a few years ago.   Some families had a line of credit against their investment portfolio and could get a loan for less than 2% a few years ago. The problem is that these loans have variable rates, and today, they cost about 5% more because of Fed hikes. Does it make sense to hold fixed-income securities that yield lower than the line of credit? Even equities, is the expected return worth it once you adjust for risk? In closing, the evolving monetary policy landscape requires a proactive approach to both investment and personal financial planning. We're in an era of transition, with the Fed's actions permeating multiple facets of the financial world. While rate hikes can be a tool to curb inflation, they also underscore the significance of adapting one's financial strategies in line with the broader economic climate.

Are inflationary expectations still anchored? The key difference between prolonged and deep stagflation of the 1970s and its milder cousins (e.g. early 1990s and post Covid) was the role played by the Federal Reserve. After Paul Volcker, the perception of its independence and the trust that consumers, corporates and investors had in the Fed’s ability to contain inflation, softened the impact of supply and demand shocks. After 1980s, inflationary expectations were mostly anchored around Fed’s targets. However, the combination of tariffs and a potentially meaningful contraction in the labor force, as well as unrelenting attacks on the Fed (including threats of sackings), seem to be starting to unanchor expectations. Where do we see this? 1. One and two year inflation break-even rates have increased from less than 2% prior to the elections to 3.4% for one year and 3% for two years. This is a meaningful jump. The only good news is that at the long end (5Y/5Y), inflationary expectations still remain anchored. 2. Most consumer and business surveys are now exhibiting a persistent pattern of inflationary expectations that range from 3% to 5%. 3. Although an average effective tariff is still below 10%, the longer tariffs stay and more efficient collection becomes, and the less pre-tariff inventory is left, the more likely we are going to see effective tariffs rising toward 15% or higher. If combined with the first labor force contraction in decades (outside the pandemic), the inflationary pass through should meaningfully increase in the second half of the year and well into 2026. 4. Finally, erratic policies, intense state interference (including kickbacks) and tariffs should imply lower production and economic efficiency throughout the economy, both domestic and externally facing. Some form of stagflation must be a given. The only question is what type: deep and prolonged or mild and short. The future of the Fed and the degree of its independence will be the deciding factor. Right now, it seems that its independence has already been at least partially impaired. While FX and bond markets are assignining a higher risk premia, equities continue to assume neither prolonged nor mild stagflation while also factoring-in strong AI returns, productivity gains and no meaningful inefficiencies. At 2.5%, SPX’s inflation adjusted equity risk premia hugs the 95 percentile (vs 6%-7% for EMU and Japan) while investors assume further expansion of the highest ever ROEs (22%) and margins (13%). And it is not just the new economy. Current expectations factor-in a return to double digit growth for the old economy as well through 2026-27. Despite the blizzard, it appears investors believe that no damage will be inflicted on either growth or risk premia. Views expressed are solely my own and do not reflect views of my employer

2️⃣ 0️⃣2️⃣ 4️⃣ Time for the Fed to embrace transparent forward guidance. In a candid assessment, Fed Chair Powell recently acknowledged that economic activity is decelerating, and inflation is receding more swiftly than expected. This is a pivotal moment for the Fed as it enters 2024 with a more balanced and pragmatic approach. It's time for the Fed to embrace transparent forward guidance, acknowledging that adjustments in 2024 will be essential, rather than reverting to vague allusions. This approach, while challenging, is crucial. Recent attempts by Fed officials to downplay Powell’s statement only serve to dilute his message, potentially undermining the Fed’s credibility. Instead, a clear narrative focusing on the desired pace and scale of policy easing could prove far more effective. This would help prevent excessive market euphoria and anchor Fed policymaking in a more forward-looking framework. Indeed, there are three reasons why the current market euphoria is excessive. Firstly, the Fed's commitment to a 2% inflation target remains unwavering. Any discussion of rate cuts will be intrinsically linked to positive developments in inflation metrics. Rate cut discussions will therefore be mechanically tied to encouraging developments on the inflation front. Since disinflation bumpiness is to be expected, current market pricing of early and rapid rate cuts seems misplaced. Secondly, economic activity will be largely influenced by ongoing cost fatigue and labor market trends. Cost fatigue is the reality that the cost of everything is much higher than before the pandemic, therefore weighing consumer spending and business investment – and leading to a massive disconnect between private sector sentiment and the underlying state of the economy. In turn, employment growth remains the main pillar to US economic activity. Surprising labor market resilience in the face of a historic tightening cycle confirmed our view that the value of talent has increased post pandemic. The question in 2024 will be whether cost fatigue or the value of talent dominate the business agenda in a context where the cost of credit remains historically elevated, but Fed easing is on the horizon. Lastly, reduced rate sensitivity in the business cycle suggests that even with the prospect of lower rates, immediate impacts on private sector investment might be limited. While the expectations of lower rates will undoubtedly prove stimulative for the deal market, it may not have an immediate and direct effect on private sector investment – rate insensitivity should be expected on the way down, just as it was a feature on the way up. In conclusion, the Fed stands at a crossroads. By articulating its commitment to a soft landing, contingent on its 2% inflation target, it can regain control of the monetary policy narrative. This approach would temper unfounded market optimism and set a course for measured and responsible economic stewardship.

The Federal Reserve just reinforced what many of us managing corporate balance sheets have suspected: more rate cuts may not be coming particularly soon. At its March meeting, the FOMC held rates steady at 4.25%-4.5%, but the bigger message was in what they didn’t say. They removed language suggesting balanced risks to inflation and employment and introduced a key phrase—“uncertainty around the economic outlook has increased.” In other words, don’t expect a clear policy direction soon. Some key takeaways… • Rate cuts are not a given. While the median projection still calls for two cuts in 2025, more FOMC participants now expect just one—or none at all. • Inflation concerns remain. Powell explicitly linked higher inflation forecasts to tariffs, underscoring how external factors are complicating the Fed’s decision-making. • Balance sheet runoff is slowing. The Fed is reducing its quantitative tightening (QT) pace to prevent liquidity stress in the Treasury market, though mortgage-backed securities will continue rolling off. What This Means for CFOs and Treasurers… For companies with floating-rate debt, this is a reminder to plan for an extended period of borrowing costs at this level. The market may still be pricing in rate cuts, but the Fed is clearly in “wait-and-see” mode. • Liquidity management remains critical. The Fed’s QT slowdown is aimed at avoiding a funding squeeze, but liquidity conditions could still tighten. • Watch trade policy closely. Tariffs are emerging as a wildcard for inflation—and, by extension, monetary policy. Powell said it best: “We are in no hurry.” Neither should we be when it comes to assuming lower rates. The best approach? Stay agile and scenario-plan rigorously. #finance #economy #policy #inflation #federalreserve #business #tariffs

Pondering the Fed's Next Move - let me jump to the conclusion: The Fed is unlikely to cut rates anytime soon and market expectations continues to be wrong. I expect the FOMC to delay policy easing until inflation data falls to its 2% target, or employment/economy show a marked decline. Economist and the financial markets have concluded that inflation is on a glidepath towards the Fed’s 2% target (CPI/PPI currently in the 3-4% range). If inflation declines to 2% in the coming year, it’s likely the result of lower demand, or slower GDP growth rates. It is remarkable that we could be talking about a 2% inflation path given the resilience of GDP and employment growth rates. The Federal Reserve’s economic models suggest that a neutral Fed Funds rate is one that is consistent with 2% inflation and full employment. If we arrive at this point, there will be no need to cut rates at all, a condition that the economic models will surely support. In other words, with growth and 2% inflation, current Fed Funds might just be necessary, negating a pivot to lower rates. The Fed will move slowly. Remember, these are the same policy folks who made significant output errors with respect to their inflation forecasting models, so they might be hesitant to lower rates too quickly, especially since employment and economic growth remains resilient. Fed policy makers are asking themselves this question: if we lower rates, will this policy action re-stimulate inflation and growth? If you were Powell, what would you do under these circumstances? Currently, inflation remains stubbornly above the Fed’s target, so I don’t expect the Fed to cut rates until we see material economic weakness which will likely not be confirmed prior to its June ’24 meeting. What makes this particularly tricky for the Fed is that after June, its subsequent meetings are July 31 and September 18, just prior to the U.S. Presidential Election. The Fed certainly does not want to be appear political by easing right prior to the November 5th election. If the Fed don’t move by June, might they wait until the November 7th meeting, which falls 2 days after the election? This game theory presents an interesting dynamic, and avoiding politics is precisely why Chairman Powell emphasizes that the Fed remains data dependent. Chairman Powell acknowledges the progress on inflation, but suggests restrictive monetary policy will be warranted, thus implying ‘Higher for Longer’. Chairman Powell: "Recent declines in measures of underlying inflation, stripped of food and energy prices, were welcome, but two months of good data are only the beginning of what it will take to build confidence that inflation is moving down sustainably... Restrictive monetary policy will likely play an increasingly important role. Getting inflation sustainably back down to 2% is expected to require a period of below-trend economic growth as well as some softening in labor market conditions."

🚨 Fed Policy News - Interest Rates Unchanged 🚨 Today, the Federal Reserve announced a pivotal decision to maintain the federal funds rate at its current range of 5.25% to 5.50%. While this outcome aligns with market expectations, the Fed's tone was notably less dovish than many had anticipated. 🔍 Analyzing the Fed's Stance The Fed's hesitation to initiate interest rate cuts stems from a strategic outlook. Despite projections from December 2023 suggesting three rate reductions in 2024 and four in 2025, the current economic climate doesn't warrant immediate action. 🚀 Inflation continues to remain above the Fed's 2% target, challenging the narrative of rapid monetary easing. Moreover, the economy, buoyed by robust GDP growth and a resilient job market, seems to be withstanding the high-interest regime, albeit with a deceleration in payroll growth. 📝 Fed's Statement Insights In their recent statement, the Fed emphasized: "The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent." The meaning? The Fed isn't ready to cut rates and wants to see more easing inflation data. 🏦 Understanding the Fed's Dual Mandate The Fed's core objectives are twofold: fostering full employment and maintaining stable prices. The current unemployment rate of 3.7% in December, coupled with over 9.0 million job openings, indicates a robust employment scenario. However, the battle against inflation is ongoing, justifying the unchanged interest rates. 📊 Inflation: A Key Factor in Future Decisions Today's Fed statement was clear: "Inflation has eased over the past year but remains elevated," and, "The Committee remains highly attentive to inflation risks." This persistence of high consumer inflation implies that the Fed is prepared to maintain high interest rates for an extended period. 🔮 Forecasting Ahead We anticipate a gradual decline in both Total CPI and Core CPI, alongside Total PCE and Core PCE. However, reaching the Fed's 2% inflation target might take until mid-2024 for Total CPI and the latter half of 2024 for Core CPI. Given these projections, our expectation is that the first Fed rate cut may not occur until Q3 2024, with June 2024 as a potential earlier date, contingent on substantial progress in curbing inflation. 💡 Stay Informed Navigating these economic trends requires keen insight and strategic planning. For continuous updates and analyses, stay connected. Share your thoughts on how these developments impact your business strategies in the comments below. #InterestRates #Finance #Economy

A recurrent theme at the press conference following the US Federal Reserve’s (Fed’s) May meeting centered around why the Fed had not yet started easing monetary policy. Fed Chair Jerome Powell’s repeated answer was that policymakers couldn’t act pre-emptively because it is unclear what they should be pre-empting: higher inflation, or weaker growth? There are three layers of genuine uncertainty here: tariff, economic and broader policy uncertainty.   1)   Tariff uncertainty: Trade negotiations are ongoing, and we do not know at what levels tariffs will settle by the end of the process. 2)   Economic uncertainty: As new tariffs are confirmed and put in place, they will rekindle inflation and have an adverse impact on growth. It is unclear at this stage which impact will dominate. 3)   Broader policy uncertainty: The US administration’s goals are to boost competitiveness, reshore manufacturing and steer toward a more sustainable fiscal outlook. Legislative work on tax cuts and deregulation is ongoing, but if achieved, should have a positive impact on the US economy.   For now, the US economy remains resilient despite the marked worsening in sentiment indicators. We face genuine two-sided uncertainty, and it is unclear whether recessionary or inflationary forces will prevail. On balance, I think it more likely that we will see growth lift again, keeping the Fed on hold and pushing bond yields higher, with the complicity of a still large fiscal deficit. But until trade representatives come out of the negotiating room, the economy is like Schrödinger’s cat: both alive and dead.

In the latest Andersen Institute for Finance and Economics The Arc blog, James Clouse discusses how the #Federalreserve September meeting is shaping up to be one of the most consequential meetings in some time, with significant risks to both sides of the dual mandate. What’s at play: -- #Inflation remains persistently above the 2% target, with growing evidence of #tariffs putting upward pressures on #prices; -- recent #jobdata revealed unexpected weakness—including downward revisions to #employment in prior months— pointing to downside risks to the #labormarket. Forecasts and market expectations: -- The President and other administration officials have suggested that the federal funds rate should already be 100 basis points or more below its current level; -- markets are pricing in a good chance (~85%) of a quarter-point cut in September; -- however, most simple #policyrule models have prescriptions for Q2 and Q3 of this year right around the current level of the federal funds rate (see https://lnkd.in/eGu6Gzgs). The balancing act – ditches and cliffs: -- Hawkish view: The #Fed risks #inflation becoming entrenched and #inflationexpectations unanchored amid accommodative #financialconditions — a “cliff” scenario. The modest “ditch” is a slight slowdown in #growth or uptick in #unemployment. -- Dovish view: Overly restrictive #monetarypolicy may push the economy toward #recession — the real "cliff". The “ditch,” conversely, is slightly higher #inflation if the #Fed eases. Ultimately, the #Fed’s decision—whether to hold steady or cut—may matter less than the signals it sends about future policy direction. Chair Powell’s comments at this week’s annual monetary policy conference in #JacksonHole may provide some clues about how he and his FOMC colleagues are now viewing the balance of risks to the economic and policy outlook. Are you in the dovish or hawkish camp? Read the blog at https://lnkd.in/e3iVu6Dh