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Fed Dancing Between The Raindrops—fighting Inflation While Avoiding Economic Hit—5-5.25% Likely Peak Funds Rate–core Services Inflation Trending Lower—positive Impact On Pce Price Index–shelter Inflation Likely Trending Lower In The Second Half— Positive Impact On Cpi

Date Posted: May 4, 2023

Fed Dancing Between The Raindrops—fighting Inflation—avoiding Recession— Fed To Keep Funds Rate Steady Until Year-end—strongly Committed To 2 Percent Inflation Objective—5-5.25% Likely Peak Funds Rate

Act One Of The Hiking Cycle Likely Ended With The Fed Increasing Its Funds By 25 Bps To 5-5.25 Percent. The Fed Signaled This Funds Rate Will Likely Prove To Be The Peak/terminal Rate When It Omitted A Sentence In Its Previous Statements, “the Committee Anticipates That Some Additional Policy Firming May Be Appropriate.” Surprisingly, The Fed Went Ahead With Its Increase With No Dissenting Committee Votes Despite Fed Economists Looking For A Mild Recession By Year-end. Time Will Tell Whether This Will Prove One Hike Too Far. Act Two Will Likely Prove More Difficult For The Fed As It Attempts To Dance Between The Rain Drops By Lowering Inflation While, At The Same Time, Avoiding An Economic Hit (See Figure 1.) The Fed Stated, “the Committee Is Strongly Committed To Returning Inflation To Its 2 Percent Objective.” This Difficult Balancing Act Will Test The Fed’s Willingness To Keep Its Funds Rate Steady To Fight Inflation Until At Least Year-end Even If The Economy Turns Down Sooner (See Figure 2.) No Doubt, In A Presidential Election Cycle, Political Pressures Will Build On The Fed To Quickly Lower Rates If The Economy Slows.

Figure 1
Dancing Between the Rain Drops

Source: S.J.Turi Artwork
Figure 2
Time Between Peak Rate and First Cut

Source: Bloomberg

Financial Markets Expect Funds Rate Cut By Year-end—looks To Economic Hit— Equity Markets Still Sanquine

Contrary To The Fed’s View, Financial Markets Anticipate A Funds Rate Cut Of 75-100 Bps To Occur During The Second Half Of This Year (See Figure 3.) More Than Likely, Financial Markets’ Expect Last Year’s Rapid And Steep Rate Increases Will Result In A Deeper Economic Slowdown Than The Fed Assumes. In Agreement With The Financial Markets, Roughly Two-thirds Of Economists Look For A Recession Beginning In The Next 12 Months–how Deep Varies. More Optimistic, Goldman Sachs Economic Research Gives Only A 35% Probability For A Recession. With All Three Major Equity Indices Up For The Year, Equity Market Investors Still Seem To Show Less Concern For A Potential Major Economic Slowdown. Instead, Equity Investors May Be Responding To Increased Earnings Estimates Looking Out Into 2024 (See Figure 4.)

Figure 3
The Expected Future Path of the Three-Month Average Fed Funds Rate

Source: Federal Reserve of Atlanta
Figure 4
12-Month Earnings Expectations Increase

Sources: @The Terminal, Bloomberg Finance LP, Daily Shot

Fixed Income Markets Look For Economic Downturn—differ From Equity Markets

Fixed Income Market Investors, However, Express More Serious Economic Concerns Than Equity Investors. A Recent Barron’s Article Pointed Out The Differing Economic Views Between The Two Markets. The Move Index, An Analog For The Treasury Market, Implies A Deeper Economic Downturn Than The Milder Outlook For The Vix (See Figure 5.) At Some Point, Differences Will Narrow As The Economy Plays Out—the Question Remains Whether The Economy Avoids A Substantial Slowdown

Figure 5
VIX Index VS MOVE Index—Calm vs Concern

Source: Barron’s, Bloomberg

Second Quarter Gdp Likely Will Show Sequentially Flat Growth With The First Quarter—slowing Consumer Spending

The First Reading For U.s. Gdp Showed First Quarter Growth Slipped From 2.6% In The Fourth Quarter To 1.1% (Saar) This Quarter. Despite The Slow Growth, Consumer Spending Grew 3.7% In The First Quarter Contributing Nearly 2.5% To Gdp Growth. Despite The First Quarter Consumer Spending Surge, Nearly All Of It Came In January. The Last Two Months Of The Quarter Actually Showed Negative Real Consumer Demand Growth. With Such Short Notice Of A Consumer Demand Surge In January, Producers And Retailers Dug Into Their Inventories To Supply That Surge. Meeting Demand Out Of Inventory Rather Than New Orders Acted As A 2.5% Drag On Gdp Growth. Normally, When Inventories Supply A Major Part Of Consumption Demand In A Quarter, In The Next Quarter, Production Should Step Up To Help Producers And Retailers Rebuild Their Inventories And Boost Gdp. However, With Consumption Dropping Off, The Current Quarter May Receive Much Less Of A Boost From Inventory Rebuilding. Initial Second Quarter Gdp Estimates From The Atlanta Fed’s Gdpnow Model Shows A Forecast Of 1.8% Growth. In The Same Report, The Blue Chip Consensus Estimates For Second Quarter Gdp Growth Range Roughly From Plus Or Minus One Percent (See Figure 6.) That Range Would Lead To Sequentially Flat Gdp Growth For The Second Quarter.

Figure 6
Atlanta Fed GDPNow Real GDP Estimate for 2023:Q2
(Quarterly percent change SAAR)

Sources: Federal Reserve Bank of Atlanta, Blue Chip Economic Indicators and Blue Chip Financial Forecasts

Services Inflation Ex Shelter One-half Of Pce Price Index—trending Lower— Potential Major Impact On Pce Index Trends

Core Services Ex-shelter Receives A Great Deal Of Focus From The Fed For The Very Simple Reason, It Contributes To Roughly Half Of The Core Pce Price Index. Therefore, The Fed Should Be Pleased By The Recent Three-month Downward Trend For The Core Services Component–reducing Pressure On The Overall Pce Price Index (See Figure 7.) If The Core Service Inflation Declines
Persists, Then The Major Cost In That Industry, Wages, Should Also Begin To Weaken From Its Current High Levels (See Figure 8.)

Figure 7

Source: Bureau of Economic Analysis,

Figure 8
Wage Growth Tracker—Services
(Median Hourly Data)

Sources: Current Population Survey, Bureau of Labor Statistics, Federal Reserve Bank of Atlanta

Lower Shelter Inflation Should Impact Price Indices In The Second Half–shelter Inflation One-third Of Cpi—potential Major Impact On Cpi Price Trends

Shelter Prices, A Second Major Component Of The Price Indices, Should Also Begin Trending Lower In The Second Half Of The Year From Their Current Upward Trends. Shelter Prices Indices Lag By 12- 13 Months Changes In The Rental And Housing Markets (See Figure 9.). This Proves Important With Shelter Prices Contributing Roughly One-third Of The Cpi And 15-20% Of The Pce Price Index. Recently Released Forecasts From The Richmond Fed Predict Rapid Shelter Price Declines Through The Fourth Quarter Of 2023 For The Pce Price Index (See Figure 10.) The Same Should Also Prove True For The Cpi But At Roughly Twice The Impact For That Of The Pce Price Index. Lower Inflation Trends For The Widely Followed Cpi Should Then Gain The Attention Of Headline Writers And Thereby Consumers. That Fallout Should Result In Reducing Closely Watched Consumer Inflation Expectations. The Potential Growing Signs Of Stabilizing Inflation Would Provide A Key Positive Influence On Consumer Attitudes, Business Planning, And Economic Forecasts.

Figure 9
Market Rent Indices Vs PCE Rent Price Index

Source: Zillow, Federal Reserve Bank of Cleveland, Bureau of Economic Analysis via Haver Analytics

Figure 10
VAR Forecast for Y/Y Growth in PCE-Rent and OER Housing Service Prices


Source: Federal Reserve Bank of Richmond

Investment Conclusions

Equity Markets: Timing Of Peak Short-term Rates Key To Financial Markets–milton Friedman Theorized That Monetary Policy Impacts Demand And Inflation With “long And Variable Lags.” That Theory Will Now Be Tested Over The Next 12 Months As The Economy Meets The Reality Of Last Year’s Series Of Steep Fed Funds Rate Increases. The Impact May Be Happening With The Ebbing Of Service And Shelter Inflation. We Will, Also, Shortly Know Whether The Fed Went Too Far By Increasing Its Funds Rate In The Face Of A Recession. Financial Market History Shows, That On Average, Equity Markets Bottom Roughly Six-months After Short Rates Peak. Ultimately, Financial Market Performance Will Depend On Whether The Economy Retreats Into A Recession Or A More Favorable Soft-landing.

Equities: A Shortage Of Growth Favors Growth Equities–whether The Economy Experiences Slow Growth Or A Recession, Either Will Result In A Shortage Of Growth. A Shortage Of Economic Growth Provides A Fundamental Reason To Look To Growth Stocks. With Economists Looking For Slow Growth In 2024, Quality Companies That Can Demonstrate Sustained Free Cash Flow And Dividend Growth Based On Above Average Returns On Capital Should Prove Attractive Investments. In Searching For Growth, Investors Should Dig Deeper Below The Most Well Recognized Names.

Fixed Income: “Income” In Fixed Income Now Carries Real Meaning–as 2023 Progresses, Lengthening Bond Duration, By Degree, Will Likely Prove Increasingly Attractive When And If The Economy Slows And Inflation Comes Down From Its Current Elevated Levels. Alternative Investments Can Also Be Used For That Portion Of The Portfolio Historically Committed To Fixed Income; Alternatives Tend To Be Less Correlated With Stocks And Bonds. That Diversification Will Also Prove Particularly Valuable With The Current Investment Uncertainties.