Will the Fed Overshoot?

Will the Fed Overshoot

Last week’s better-than-expected inflation report brought relief to markets. Both stocks and bonds rebounded as investors anticipated that the Fed won’t have to be as aggressive in raising rates to tame runaway prices.

We recommend that investors, business owners, and families take this news in stride—a positive development at a time when the inflation outlook still remains challenging and economic growth is likely to slow materially in 2023 (see our comprehensive outlook here).

Keep in mind that investment markets tend to react the most BEFORE recession occurs, should one do so. We have adjusted client portfolios over the past year in light of these developments—and continue to do so, given that bond yields have improved considerably.

We share our latest thoughts on inflation and the economic outlook in this report.

Inflation Still a Challenge

While lower headline inflation was welcome news, we do not believe the inflation challenge is behind us yet.

On the positive side, the Fed may not have to “go as high” with its target rate. The Fed has been aggressively hiking rates this year, and markets were expecting the Fed funds rate to top 5% sometime in late spring 2023 (its policy range is 3.75% to 4% now). If top-line inflation is already cooling, perhaps it won’t have to go that high. Good news there.

On the more cautious side, we believe the Fed will remain aggressive in fighting inflation. This is because while some price pressures have eased—such as for products in high demand during the pandemic[1]—they have continued to rise in other areas like the services sectors, where the economy continues to hum. Services are a larger part of the economy and tend to be more labor intensive, where tight labor markets persist.

For reference, inflation in services in October continued to climb from the summer and is now 6.7% annually. There are some puts and takes to that number[2], but overall the risk is that tight labor markets raise risks of inflation becoming entrenched—i.e., wages needing to keep up with inflation and to escalate to attract limited workers.

Overall, we expect inflation may hover around 6% for the foreseeable future, requiring the Fed to remain committed to fighting the trend. It’s stated long-term goal is 2%, indicating that the Fed believes it still has work to do. Remember that year-over-year comparisons should improve around summer 2023 if the Fed’s policies are effective.

Higher Rates Already Having an Impact

Fed rate hikes are already having impact in rate-sensitive sectors like real estate and residential construction. Arguably, a recession has already begun there. Consider that:

  • Mortgage activity is down a reported 40% annually once rates like the 30-year fixed mortgage rate topped 5.5% or so.
  • Sales of existing homes dropped over 25% by September since the start of the year.
  • Hiring in these areas has started to slow as well, as shown in the October jobs report.
  • Construction backlogs may ease the immediate economic impact, since projects that are already funded and committed should roll into spring and summer next year.

Capital markets have also responded by curtailing activity considerably. Overall activity through October this year is down more than half compared to each of the last two years and is on par to be the weakest since 2011[3].

Unemployment Data Tends to Lag

That said, the US economy overall is still adding jobs at a rate above pre-pandemic levels and unemployment is very low. Wage pressures persist, evident in most sectors looking to fill jobs to meet strong demand. Until (core services) inflation begins to fall, the Fed’s work is not yet done.

The challenge to taming inflation is it takes time for policy to filter through the economy, even as expectations for inflation influence more immediate decisions. GDP growth and unemployment levels are lagging indicators of impact, so the Fed needs to send a strong signal to influence more real-time activity.

For this reason, we believe the Fed inevitably overshoots on raising rates. The Fed’s minutes from the October rate increase said as much, in our view: to paraphrase, “the costs of doing too little… outweigh the cost of doing too much.”

BOTTOM LINE

Fed policy is already having an impact in the most rate-sensitive parts of the economy. It takes time, however, for rates to filter into broad economic activity.

From an investment standpoint, we do not believe investors should overact to headlines about inflation, growth, or unemployment if they have a solid strategy that matches their risk profile.

Capital markets are forward looking and tend to go down the most BEFORE a recession is reported. As we have discussed throughout the year, markets have already fallen in anticipation.

Earlier this year, we implemented strategies designed to reduce equity volatility and enhance yield in a low-yield environment, as inflation risk mounted. Improved yields today offer opportunity to adjust portfolios, as appropriate, again, with implications for strategy in both fixed income and equities.

We recommend allowing a diversified allocation approach to do its work, including rebalancing, so that investors can sufficiently navigate uncertain periods.

[1] Products in demand during the pandemic (like used cars, furniture, and apparel) are seeing prices moderate now as supply chains ease and bloated inventories start to run off. Inflation for those “Goods” has improved from double-digits to about 5%.

[2] Inflation in services during October were helped by a one-time reset of medical insurance premiums for the coming year, which will help. Potentially offsetting that benefit, medical labor costs remain high and reimbursement rates for hospitals have been set higher for 2023. Also, rent inflation already shows early signs of easing, but it may take six months to work into the economy as rental agreements renew in size.

[3] According Dealogic’s analysis of M&A, leveraged loans, IPOs, and CLOs (collateralized loan obligations).

Share on Facebook
Share on Twitter
Share on LinkedIn

Leave a Comment

Let us help your assets and
life appreciate, together.

Receive CornerCap Updates & Insights

This site is protected by reCAPTCHA and the Google Privacy Policy and Terms of Service apply.
This field is for validation purposes and should be left unchanged.