Confused yet?

It was a week of inconsistencies.

    • Inflation has been down; now CPI and PPI are up.
    • Retail sales were strong; now they are weak.
    • Manufacturing PMIs are up; Industrial production is down.
    • Lay-off announcements are up; initial jobless claims are down.

For a data dependent Fed trying to time interest rate reductions, the data isn’t helping very much. The Fed’s economics team is comprised of some of the ‘smartest guys in the room’, yet even they have problems figuring this out. The proof is in all the past policy errors that have emanated from the Fed over past decades.

Wall Street appears to be thinking about this in terms of whether the Fed can come up with the right recipe for success. We consider that a poor analogy. There is no recipe. We see these as the questions to be answered:

    • Will circumstances give the Fed the opportunity to make a good decision? The first obstacle to having a good outcome from a Fed policy shift is having circumstances that make the job less complicated. All through last year, it appeared that a policy shift to lower interest rates would require employment to materially weaken in order for inflation to come down. Under those conditions, it is very hard for the Fed to thread the needle and create a good economic outcome. What has changed over the last several months is that inflation has come down despite employment remaining strong. In other words, the circumstances are giving the Fed a much better shot at creating a good economic outcome.

The second question is whether the signals used to make the rate reduction call are the proper signals this time around.

    • The Fed is data dependent, but which data are they dependent on? Again, there is no recipe. These are judgment calls by each Fed governor that gets translated into policy. The Fed works under a very specific mandate comprised of two things: price stability and full employment. At the moment, price stability is their problem, not employment.

Here is how we translate that into likely Fed policy:

    • Employment has weakened modestly over the past year but remains quite robust overall. Rate cuts are typically used to kick-start the economy in response to weak employment. That certainly isn’t the case now, which allows the Fed to be very patient when considering rate cuts. The thing most likely to accelerate rate cuts is a much weaker employment situation, but that is nowhere in sight, at the moment.
    • Inflation has come down and is approaching the Fed target of 2%. Yes, inflation is coming down, but the CPI and PPI reports this week were higher than expected, particularly PPI, which is a leading indicator for CPI. Of course, a one month rise is not necessarily a trend. The Fed has made it very clear that they want to see inflation ‘sustainably‘ at the 2% target. They don’t want to cut rates too soon at the risk of a resurgence of inflation. From their perspective, that is the worst of all possible outcomes.
    • If you were in their position, what would you do? Probably the same thing the Fed is doing – nothing! The employment situation gives them plenty of leeway to be patient with rate cuts. It also gives them the flexibility to raise rates again, should inflation move higher for some unforeseen reason. The one thing that would really push them to lower rates sooner rather than later is a weaker than expected employment situation and that is simply not the case today.

The stock market needs to get used to the idea that it is unlikely that rates will come down soon or quickly. If inflation stays down, rates will most certainly be reduced at some point this year, but there is no need for the Fed to hurry as long as the employment picture remains robust.

If the labor situation deteriorates materially, we should expect the Fed to respond with more urgency. However, that also represents another set of risks to the economy.

For now, the market seems locked in the belief that the rate decision will be easy and the economy continues to churn forward, but we have to believe that much of that optimism is already baked in. From the low of mid-October, the S&P 500 has risen 1.3% per week on average (21.6% total) for the last 15 weeks.  It has taken a mere 15 weeks to produce what would be considered an excellent year for the stock market. If we extrapolate those returns to a full 52 weeks, the S&P 500 would climb about 94% in that one-year time frame! Call us crazy, but that sounds more than a little optimistic. In short, we’re looking out for a correction.


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By: thinkhouse