Can the Fed Stick the Landing?
Since the Pandemic, the Federal Reserve reminds me of a gymnast that utterly failed his Floor exercise but is trying desperately to stick the landing on the Uneven Bars.
Hindsight is always 20-20, but as inflation was getting going in 2021 the Fed was far too slow to adjust its policy stance. Believing that increasing prices were primarily a function of broken supply chains, the Fed maintained its zero-interest rate policy and aggressive purchases of government and mortgage-backed bonds into early 2022, well after the economy began experiencing mid-to-upper single digit inflation starting in April 2021. While it is understandable why the Fed placed much of the blame on supply chains, a failure to appreciate the impact of the $5.2 trillion in fiscal stimulus related to the Pandemic, equivalent to about 25% of GDP, on the prices of scarce goods and services is confounding. The Fed blew the Floor exercise.
However, since 2022 the Fed has, to this point, engineered a reasonably solid Uneven Bars routine. After taking longer than originally expected, supply chains have returned to (almost) normal. Energy markets that saw prices spike in the first half of 2022 caused by Russia’s invasion of Ukraine have normalized. The Fed’s own aggressive interest rate increases, coupled with its reversal of bond buying, have restrained demand in the interest-sensitive housing and auto markets without hurting the service sector. All of this has occurred while the labor market remains strong, allowing the economy to avoid recession.
But as the recent firming of still-elevated inflation illustrates, sticking the landing is going to be tough. Work done by Princeton economist Alan Blinder illustrates how difficult the job can be. Since 1965, Blinder concludes that out of 11 tightening cycles the Fed has only been able to engineer one clear soft landing, defined as returning inflation to low levels without causing a recession, in the mid-1990s. If history is a guide, one out of 11 isn’t very good odds.
Even so, economists and markets have bought into the Fed achieving a soft landing. In the April Wall Street Journal’s business and academic economist survey, only 29% of the 70 participants forecast a recession during the next twelve months, the lowest percentage since the April 2022 survey of 28%. Investors have endorsed this view with their pocketbooks as stocks have rallied about 25% since October 2023, supported by the belief a strong economy will generate double-digit earnings growth in each of 2024 and 2025.
Will the Fed be able to do it? I think it’s possible, but it will take good judgment, help from politicians in Washington and some luck.
Falling energy and commodity costs have been a big contributor to bringing overall inflation down to around 3%, but reversals for both recently due to continuing wars in Ukraine and the Middle East imply these easy gains are gone. Core inflation that excludes food and energy hasn’t budged much from the 4% level achieved last summer. The Fed’s preferred inflation gauge, the Personal Consumption Expenditure (PCE) index, shows the same pattern but runs about one percent less due to its lower mix of elevated housing inflation. The PCE is still too high for the Fed’s liking.
The Fed last raised the Federal Funds rate to a range of 5.25%-5.5% in July 2023, about 10 months ago. Interest rate increases work with a lagged effect to slow the economy. While it is widely believed that the full impact of an increase is felt after about a year, some economists believe it can take longer. We might just need to be more patient to see if the last few Fed rate hikes have fully worked their way into the economy.
The Fed believes this level of interest rates is restrictive, although the housing and automotive sectors have recently stabilized. Further challenging the Fed’s belief is the strong employment market and GDP growth approaching 3%. If this strength continues, the Fed will likely hold rates steady rather than pursue any interest rate cuts, regardless of market expectations. Holding rates steady heightens the chance for a policy mistake if the recent inflation readings turn out to be a bump in the road on the way to lower inflation rather than a new normal. On the other hand, cutting too quickly might stimulate already strong demand, causing inflation to rise – this was the mistake of the 1970s. The Fed’s judgment will be tested.
The Fed could also use some help from Washington D.C. One way would be helping to end the wars in Ukraine and the Middle East as peace would stabilize energy markets. Another would be pursuing a more restrictive fiscal policy through spending cuts, tax increases, or a combination that would remove dollars from consumers’ pockets to slow overall consumption. Cutting regulation would also reduce prices. There seems little appetite in Washington to pursue spending cuts or regulatory reform. However, in a polarized Washington and in an election year the pressure on the Fed will be to goose the economy through lower rates rather than worry about attaining its inflation target. The Fed must have the fortitude to resist political pressure.
The Fed also needs to do its work without any major external shocks. Unfortunately, there are some in plain sight as wars can have unpredictable events. Further, ramping up tariffs could lead to disruption of trade flows causing shortages that would hike prices.
While the market has softened recently as it has become clearer that the Fed won’t be cutting rates as much as expected, investors are encouraged by stronger economic growth to support earnings. For those that own real estate or stocks, the long-term impact from slightly higher inflation should be at worst neutral as landlords and companies can raise prices to offset their higher input costs, including costs of capital. However, consumers, particularly lower wage earners, suffer as their dollar buys less. The Fed is doing the right things to stick the landing, but I’d like to see the politicians do more to help make sure it happens.
Dan Boyle, CFA