The Fed hikes rates and suggests a pause, but is still fighting the last war

WELREX® Director John Longo shares his view on the latest meeting of the Federal Reserve

The Federal Reserve raised interest rates 25 basis points last week, bringing the Fed Funds rate to 5.25%, a generational high. Equity markets rallied modestly on the news after parsing the Fed’s published statement. For the first time in several months, the Fed dropped from its statement the phrase that “the Committee anticipates that some additional policy firming may be appropriate.” If it looks like a pause…

The Fed’s behavioural error

The Fed has acknowledged what is obvious to most consumers.  That is, it was late in addressing the inflation problem. In an effort to put the inflation genie back in the bottle, the Fed embarked on its most aggressive rate hike campaign since the 1980s. When most people make a mistake, they try not to make the same mistake twice.  Hence the Fed sharply increased short-term interest rates to try to stomp out inflation. But most critical analyses of the data show that inflation is coming down and there is nothing magical about the Fed’s 2% inflation target. In fact, inflation has averaged more than 3.5% in the U.S. since the early 1900s and the economy has functioned well, by and large. In short, the Fed is fighting the last war, increasing the odds of recession and acting as a catalyst for the regional banking crisis.

CPI and PPI both falling

Both the Consumer Price Index (CPI) and Producer Price Index (PPI) are noticeably falling, as shown in the graphs below. On a month-to-month basis the numbers may be quite volatile, but as we have discussed in our prior writings, the numbers are very likely to continue their downward trajectories due to the base effect. As we approach the summer, the high CPI and PPI numbers will roll off, making it a virtual mathematical certainty that inflation will continue to fall.  Simply because a “double dip” inflation scenario occurred in the past, it does not mean that is has to occur again. Demographic changes and the increased use of technology in our lives are generally viewed as secular deflationary trends.

Consumer Price Index: April 2022- March 2023


Producer Price Index: April 2022- March 2023


Buffett’s comments and a wealth of other slowing economic indicators

Berkshire Hathaway’s legendary shareholder meeting was held last weekend in Omaha, Nebraska. As usual, Warren Buffett and his business partner, Charlie Munger, opined on a variety of topics. Berkshire is probably the world’s most famous conglomerate and hence has a decent view of the U.S. economy. Buffett cited expected earnings declines in 2023 across a range of Berkshire subsidiaries. He also felt deposits in the banking system were safe, but expected issues in the banking system to continue. Importantly, he didn’t say he was buying any banking stocks and simply talked about his existing large position in Bank of America. As a consequence of the regional banking crisis, it is common sense that banks will be lending less, slowing down inflation and the economy.

The inverted yield curve and sluggish Institute for Supply Chain Management (ISM) Manufacturing and Services purchasing manager indicators increase the odds of a recession despite last week’s strong unemployment report ahead of the summer holiday season. Leisure and hospitality jobs accounted for a sizeable portion of the job gains, and these professions generally pay less than those jobs that were lost in the Tech and Financial sectors. The (almost) annual U.S. Debt Ceiling standoff will very likely get resolved, but it may create further market jitters. The Fed continues its quantitative tightening program, which is the equivalent of several rate hikes, over time. In sum, we expect a sluggish U.S. economy with the odds tilted towards a recession due to Fed policy errors. Investment portfolios should be structured accordingly.

John M. Longo, Ph.D., CFA




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