February
27
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Recession – The Fed says “it’s different this time”
By David Nelson, CFA
Markets have always climbed a wall of worry and this year is no exception. High on the list of investor concerns is inflation data that may not be falling fast enough for many officials in the FOMC. There’s a reason why they say the Fed keeps hiking until something breaks. All to often that is exactly what happens.
It’s pretty clear that peak inflation is in the rear view mirror but there’s still a long way to go to get to the Fed’s target of 2%. Recent statements from FOMC members suggests the Fed will keep hiking until they get inflation and employment data that confirms they have tamed the beast.
Bloomberg Data
The danger in that thinking is the time lag between Fed policy and when those actions actually show up in the data. Think of the U.S. economy like it’s a super tanker. A good captain knows he has to start his turn well in advance and even more important start slowing down miles from port.
Raphael Bostic Atlanta Fed President wrote on long and variable lags in a paper from November, 2022. His following statement should be read several times until it sinks in.
A large body of research tells us it can take 18 months to two years or more for tighter monetary policy to materially affect inflation. – Raphael Bostic
We’re not even one year into the hiking cycle so likely not enough time for the medicine to work. Coming into last week, markets had priced out the idea of any Fed cuts later this year but what they hadn’t priced in was a terminal rate that would continue to march higher.
For stocks to regain their footing, at a minimum the terminal rate has to stop going up.
In past cycles the Fed has often driven rates up beyond the inflation rate or at the very least met it. Recession was almost always the end game.
It’s different this time
Recent rhetoric from the Fed and many economists is the idea that the Fed can engineer a soft landing. In other words, “it’s different this time.”
Bloomberg Data
With the last CPI reading at 6.4% and the Fed Funds headed to at least 5% next month, I expect the two data points will cross sometime before the end of 2023. A fed funds terminal rate of 5.5%-6.0% adds another brick to the wall of worry.
Bloomberg Data
The setup up in the second half of the year continues to look better. We should be at or close to a peak Fed Funds rate and beyond the Debt Ceiling crisis which is still the biggest near term risk for the market. Come July portfolio managers will shift their focus to 2024 and the 12 month look ahead for earnings which should look a lot better than 2023.
DAVID NELSON, CFA 