Economic Monitor – Weekly Commentary
by Eugenio Alemán

The Federal Reserve: Between a rock and a hard (market) place

September 13, 2024

The Federal Reserve (Fed), and markets, overreacted to the slightly higher inflation seen during the first quarter of the year. After that scare, the Fed went from expecting three cuts in the federal funds rate in 2024 to just one cut during its June dot plot release. Meanwhile, the markets went from expecting six to seven rate cuts in 2024 back in December of 2023 to barely one cut a little more than two months ago. Overreaction is how the market reacts to new information and, in the end, is the nature of the beast.

But the Fed should know better. We understand the increase in the institution’s risk aversion generated by higher inflation and potentially higher, ‘unanchored’ inflation expectations. This is what happened during the 1970s and 1980s, a period that was called ‘stagflation,’ which combines very high inflation with very low economic growth. In our writings during the last two plus years, we have been fighting the idea that the current period bears any resemblance to the stagflationary period of the 70s and 80s; however, we understand Fed officials’ fears about being careful not to agitate the inflation expectations waters.

At that time, inconsistent monetary policy as well as severe external shocks (a 184% increase in the price of petroleum in 1974 followed by a 149% increase in 1980) came together to create a perfect storm. Today, we still have an independent Fed and consistent monetary policy while we have been coming back from a very severe external shock, the COVID-19 pandemic, and a relatively smaller shock, the Russia-Ukraine war. But the effects of the pandemic and the war have been fading and thus the consistent monetary policy has taken over and is bringing inflation down to the institution’s target.

In the U.S., the inflation target is 2.0% for the Personal Consumption Expenditure Price Index over the long run.1 Back in the 70s and 80s the Fed did not have an inflation target, and monetary policy was conducted in a more, let’s say, discretionary way than today. However, today, the Fed has to stick to its target and do whatever it needs to do to bring inflation down to that target. If it needs to keep interest rates high or higher for longer, it will do so.

Today, markets are overshooting again, pricing in almost 250 basis points in cuts between now and December 2025. We believe this is way too aggressive and that Fed officials are not ready to go along with such market expectations, especially if the economy continues to grow. For the market to expect such a strong reduction in rates, it would have to believe the economy is going into recession and so far, that doesn’t appear to be the case.

We still believe that the Fed is going to cut 25 basis points in September, probably another 25 basis points in November, and potentially another 25 basis points in December. Our argument is consistent with what we see in the economy as employment continues to slow down and inflation continues to approach the 2.0% target rate.

That is, today’s real federal funds rate (nominal fed funds rate minus inflation) is too high and has started to have a negative impact on economic activity, so the Fed is just adjusting its policy rate to take into account these factors. Thus, we now have three 25 basis points cuts this year but will wait for next week’s dot-plot to update our forecast on rates.

But the Fed must deal with several challenging issues today. First, the fiscal tailwinds are still alive and well—the fiscal expansion created by the CHIPS, IRA, and Infrastructure Acts have many years to go. Second, as we said before, employment is slowing down and is affecting economic growth. Third, the rate of inflation has continued to come down and is expected to hit the 2.0% target early next year, and ahead of the Fed’s schedule, according to our calculations. However, shelter costs remain an issue even in this, highly benign inflation environment.

Our argument for a more methodical/slow movement down with rates has to do with shelter costs. Typically, the Fed lowers the federal funds rate to affect long-term rates. The most important of these rates is the 30-year mortgage, which more than doubled over the last several years. But the 30-year mortgage rate has come down already this year as it typically follows the behavior of the yield of the 10-year Treasury. This reduction in the mortgage rate has started to benefit residential investment and the overall housing market.

However, a much lower federal funds rate has the potential for ‘super-sizing’ these effects on the housing market and put further upward pressure on home prices. Thus, we believe that the Fed is going to be very careful as it moves rates lower so it doesn’t create a large mortgage lending cycle that could threaten its inflation target in the years to come.

In conclusion, fiscal expansion will continue to support nonresidential investment, and we believe that the Fed wants to help residential investment. However, it will have to do this with caution, so it doesn’t contribute to a large mortgage lending cycle that will have the potential to send home prices much higher and potentially threaten the inflation target down the road.

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Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those Raymond James and are subject to change without notice the information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the U.S. Bureau of Labor Studies. Currencies investing are generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

The National Federation of Independent Business (NFIB) Small Business Optimism Index is a composite of ten seasonally adjusted components. It provides a indication of the health of small businesses in the U.S., which account of roughly 50% of the nation's private workforce.

The producer price index is a price index that measures the average changes in prices received by domestic producers for their output. Its importance is being undermined by the steady decline in manufactured goods as a share of spending.

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