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Fed Manages Unprecedented Tightening Cycle—core Inflation Outlook Trending Favorably–declining Wage Increases Will Likely Reflect Pass-through Of Lower Future Inflation—history Shows Relative Stable Equity Markets In Presidential Election Year — July Funds Rate The Peak Rate?—peak Rate Continues Some Time Into 2024

Date Posted: August 21, 2023

Fed Manages Unprecedented Tightening Cycle—so Far Successfully—reduced Inflation While Unemployment Remained Historcally Low

The Recent July Consumer Price Index (Cpi) Report Underscores The Fed’s Apparent Success, So Far, In Effectively Managing Inflation While Simultaneously Keeping Historically Low Unemployment Rates. This Achievement Would Mark An Unprecedented Tightening Cycle. The Uniqueness Comes Primarily From The Unprecedented Speed At Which Interest Rates Rose To 5 Percent In A Little More Than A Year While Inflation Decelerated Faster Than Many Expected. In Contrast To Previous Rate Hiking Cycles Since 1987, A Chart From The Richmond Fed Shows The Speedy Deceleration Of The Personal Consumption Expenditures Price Index (Pce) Inflation (See Figure 1.) Figure 2 Then Demonstrates The Minimal Change In The Historically Low Unemployment Rate During This Tightening Cycle. Only Time Will Determine Whether The Delayed Impact Of This Tightening Cycle Will Alter These Unique Outcomes. Thus Far, The Stable Unemployment Rate Shielded The Fed From Political Pressures To Loosen Its Tight Monetary Policies. That Might Not Prove To Be The Case During Next Year’s Presidential Election Campaign.

Figure 1

Rapid Decline in PCE Price Index Inflation Compared to Other Tightening Cycles Since 1987


Sources: Bureau of Economic Analysis, Haver Analytics, Federal Reserve Bank of Richmond

Figure 2
Unemployment Rate Remained Historically Low Compared to Other Tightening Cycles Since 1987


Sources: Bureau of Economic Analysis, Haver Analytics, Federal Reserve Bank of Richmond

Goods Inflation Drops Sharply As Price Discounts Reduce Excess Inventories

During The Covid Pandemic, Consumer Demand Surged Following The Distribution Of Federal Stimulus Checks. This Led To Supply-chain Disruptions As Businesses Doubled And Tripled Orders To Refill Their Inventories. However, These Double And Triple Orders Further Increased The Supply- Chain Disruptions. Once The Pandemic’s Grip Eased, Consumers Gradually Shifted A Portion Of Their Spending Towards Various Services From Goods Enabling Supply-chains To Stabilize. As A Result, Suppliers And Retailers Found Themselves Holding A Surplus Of Excess Inventories. To Move Out Their Excess Inventories, Suppliers And Retailers Resorted To Sharp Price Discounts. Their Actions Resulting In A Rapid Decrease In Goods Inflation (See Figures 3 And 4.) With Supply- Chains Now Opened And Excess Inventories Moved Out, Goods Inflation Will Likely Return To The Normal Influences Of Supply And Demand.

Figure 3
Wholesale Inventories 2nd Quarter 2023 by Month

Sources: Bloomberg, BofA GLOBAL RESEARCH

Figure 4
Core CPI Inflation—Services, Goods, and Total Inflation


Sources: Bureau of Labor Statistics via Haver Analytics

Annual Rent Decreases Will Continue To Moderate Core Cpi Inflation

With Approximately 40% Of The Core Cpi Attributed To Shelter Prices, The Extent To Which Core Cpi Service Inflation Moderates Will Depend Importantly On How Fast The Rate Of Annual Rent Increases Decelerates. The Declining Trend In Annual Rent Increases Should Lead To Favorable Core Cpi Inflation Reports (See Figure 5.). If These Core Cpi Inflation Trends Continue, The Data Dependent Fed May Not Find A Sufficient Basis For Raising The Funds Rate.

Figure 5
Housing Components of CPI

Sources: Macrobond, ING

Key Driver Of Wage Increases–inflation Not Labor Market Imbalances

The Fed Uses The Personal Consumer Expenditures Price Index (Pce) As A Key Metric For Measuring Its Success In Softening Inflation. Unlike The Cpi, The Pce Price Index Assigns A Lower Weight Of Only 20% To Shelter Prices. Instead, Services Ex-shelter, Contributes Over 50% Of The Pce Price Index. Therefore, Reducing Future Labor Costs Will Be Pivotal To Driving Down Service Ex-shelter Inflation As Well As Achieving An Overall Decline In The Pce Price Index. The Cleveland Fed’s Research Provides Some Optimism For Potentially Easing Wage Pressures. Their Research Points To Upward Wage Pressures Since The Pandemic Primarily Reflected The Pass-through Effect Of Higher Inflation Rather Than Labor Market Imbalances. According To Their Projections, Wage Growth Will Likely Decline, Over The Next Three Years, To Under 3 Percent. That Forecast Reflects The Pass-through Of Lower Future Inflation (See Figure 6.) Alternatively, Wage Increases In The Range Of 3-4% Would Prove Sufficient For The Fed To Achieve Its 2 Percent Inflation Goal. In Our View, The Alternative Seems More Likely. If The Cleveland Fed’s Forecast Proves Close To Target, The Fed Should Be Able To Achieve Its 2 Percent Inflation Goal Within The Timeframe Outlined In Their Projections.

Figure 6
Wage Growth Forecast—2023: Q2–2025:Q4

Fed Pause Likely For Both Its September And October/november Meetings—peak Rate Likely Continues For Some Time Into 2024

If Core Inflation Continues To Soften And Economic Data Remains Favorable Beyond September, Then The Fed Would Likely Keep Rates Unchanged At Its Next Meeting In November As Well. This Could Indicate That The Last Rate Hike In July May Also Turn Out To Be The Peak Rate. Nonetheless, The Fed Will Likely Maintain This Peak Rate For Some Time Into 2024. This Perspective Reflects The Fed’s Recognition Of Its Failed Stop-and-go Funds Rate Policies Implemented During The Inflationary Seventies (See Figure 7.) These Failed Policies Underscore The Potential Risks Of Loosening Monetary Policy Prematurely In Response To Early Signs Of Inflation Slowing. If The Economy Remains Stable, Futures Market Expectations For A Rate Cut Early In 2024 May Prove To Be Overly Optimistic.

Figure 7
CPI Inflation (1970’s vs last 10 years)
(Blue Line U.S. CPI Y/Y% 3/31/1966-12/31/1982)
(Orange Line U.S. CPI Y/Y% 9/30/2013-6/30/2023)

Sources: @JeffreyKleintop, Bloomberg, The Daily Shot

Investment Conclusions Presidential Election Year Stock Market Performance: Under The Category “for Whatever Its Worth,” The 4-year Presidential Election Cycle History Suggests That Stock Markets Tend To Perform Best In The Pre-election Year. So Far, This Year’s Market Performance Meets That Expectation. In The Case Of The Presidential Election Year, History Shows Relatively Stable Upward Market Movement Until After The November Election (See Figure 8.) Following The Election, History Shows Equity Markets Tend To Increase For The Remainder Of The Year

Figure 8 Equity
Performance vs 4 Year Presidential Election Cycle

Cyclicals: An Economic Rebound From A Soft-landing, No-landing, Or Mild Recession Will Likely Determine The Timing And Potential For A Cyclical Earnings Recovery. In Our Mind, We Debate Whether The Likely Soft-landing Will Be Short-lived Or More Prolonged, Followed By An Eventual Cyclical Recovery. As Signs Of An Economic Recovery Become Evident, Investors Will Increasingly Focus On Cyclical Stocks. During The Initial Phase Of An Economic Recovery, Increasing Optimism Should Spark An Increase In Consumer Cyclical Product Demand And For The Broad Group Of Stocks In That Sector..
Cyclicals:  Industrial Policies-support Economic Resilience: The Government’s Focus On Implementing Its Industrial Policies Should Create Favorable Conditions For Select Cyclical Stocks. Specifically, The Industrial Policies Provide Attractive Tax Credits And Direct Government Investment For Infrastructure Construction, Green Projects, And Semi-conductor Production And Research. These Sectors May Offer More Sustained Long-term Cyclical Growth Opportunities Compared To Cyclical Stocks That Rely Primarily On An Economic Recovery. Continued Development Of These Policies Should Also Contribute To The Current Economic Resilience.
Fixed Income: As The Fed Approaches Its Peak Funds Rate Decision, Moderately Extending Fixed Income Duration Continues To Be Appealing, Particularly Given The Recent Rise In Long-term Rates. If The Economic Outlook Improves, Lower Rated Debt May Also Prove Attractive In Such A Scenario. Incorporating Alternative Investments Can Also Be Used To Diversify The Portion Traditionally Committed To Fixed Income. Alternatives Provide Lower Correlations With Stocks And Bonds, Providing Diversification Benefits. Exploring Alternative Investments Can Help Manage Risk And Potentially Enhance Returns In A Changing Market Environment.