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Chasing The Gap

CAMS Weekly View from the Corner – Week ending 9/23/2022

September 26, 2022

This past Wednesday Chairman Powell informed us that the Federal Open Market Committee (FOMC) – the body within the Federal Reserve that sets interest rate policy – increased interest rates by an additional ¾%. When we say they increased interest rates by X amount what they are doing is increasing their Federal Funds Rate. This is the rate banks within the Federal Reserve System charge one another for overnight loans. This is the interest rate the FOMC has direct control over. We offer this as many get confused as to what the Fed is doing when they change interest rates. By doing this they are tightening financial conditions and sending a message as such and then other interest rates across the economic spectrum change in a similar manner – sometimes more sometimes less. They, for example, do not have direct control over mortgage rates. Many types of well known interest rates take their cue from collective market participants in the Treasury bond market. This is why Treasury bond market trends are so important to the citizenry. Said market participants look at a plethora of inputs as to how they feel they want to price Treasury bond rates with the path of the Fed Funds Rate being just one of them. This is meant as a brief and succinct under-explanation of a complicated process and interaction but nonetheless felt it timely to offer a quick peek into the process. Chasing the Gap

“The FOMC is strongly resolved to bring inflation down to 2%, and we will keep at it until the job is done.” Chairman Powell Post FOMC Meeting Press Conference

Strewn throughout numerous editions over the past year and a half we have offered the relationship of price inflation and the interest rate policy of the Federal Reserve.  The bottom line has always been and remains that price inflation is way out in front of interest rate policy and with this the Fed was and currently is behind the price inflation curve. Our above header quote from Chairman Powell taken from Wednesday’s press conference offers a strong resolve to get price inflation back down to their multi-decade stated price inflation stance of 2%.  There are many price inflation measures but to offer perspective the well recognized Consumer Price Index (CPI) remains just north of 8%.  We can see the 2% objective is miles away from our current price inflation experience. Even with Wednesday’s Fed rate hike their Fed Funds rate is only up to the 3% level while price inflation is north of 8%.  Below we offer visual perspective.

The above chart encompasses the previous two decades with the faint red line depicting the CPI while the faint blue line identifies the Fed Funds Rate.  Per our inserted red vertical line we are highlighting the tremendous gap between the two even with the most recent increase in interest rates by the Federal Reserve. The Fed is chasing this gap and as offered remains terribly behind the price inflation story.  Furthermore, as the Fed chases this gap, per their messaging in print and verbally in press conferences they are expecting (hoping?) as their interest rate is increased the identified CPI will be dropping.  This would then equate to, down the timeline, both meeting each other somewhere in our depicted gap within the chart above. If this occurs the Fed will not have to continually raise rates as the price inflation measures (pick your favorite) move consistently lower.  With this in mind though, as an important aside and as shared in our previous edition, two measures from the Cleveland Federal Reserve District Bank that are designed to give a deeper read into the price inflation backdrop – Median CPI and 16% Trimmed CPI – were trending new highs as of their most recent updates. Obviously that fact is not depicting a down trending price inflation story currently. The Federal Reserve Itself Remains Inflationary It is always about the word “real” in economics.  Simply when real precedes anything it offers that it has been adjusted relative to price inflation – hence real – not smoke and mirrors but rather what is the real story. Side example – wages are up 5% but price inflation is up 8%.  Said wage earner did not get a pay raise rather they lost ground i.e. their real wage growth rate is negative 3%.  Okay you get it. (Btw – real wage growth rates have been negative for 18 months and counting – hold thought for future edition.) With all of the talk about how aggressive the Fed has been in raising interest rates they are terribly behind the price inflation story as we have offered above.  It gets worse. Their Fed Funds Rate – when adjusted for price inflation i.e. their real Fed Funds Rate – remains historically negative – as in 70-plus years historically negative!

For a broad perspective the above dates back to the early 1950’s.  Our red horizontal line emphasizes that our current real Fed Funds Rate has never been this low in the multi-decade storyline the chart presents. The backdrop story is when a monetary authority (Federal Reserve) has a real benchmark interest rate (think their Fed Funds rate) that is negative (below the black horizontal zero line above) this is known as an “accommodative policy stance” which is also known as an inflationary policy stance. Generally speaking there are two ways in which a monetary authority gets to a negative real benchmark interest rate.  The first is by design.  Let’s say they have a building deflationary backdrop developing or already unfolding they can lower their interest rate much lower than the inflation rate.  By doing this they are considered to be in an inflationary policy stance. The second way said authority gets to negative real interest rates is they lose control of the price inflation backdrop and it speeds upward in an out-of-control type trend.  Sound familiar?  With this, as the above chart depicts, their interest rate falls terribly negative when price inflation is factored in – i.e. their real Fed Funds interest rate falls dramatically. Per our above chart we can see, even with the consistent interest rate increases by the Federal Reserve in recent months, current day they remain far behind the price inflation story to the point that their policy stance is considered to be inflationary, or accommodative, as it is referred to as in general economics. So yes the Fed’s current interest rate policy stance is an inflationary stance via their historic current negative real interest rate.  (Ponder that reality for a moment.) With all of the historical data shared above the often casually assumed conclusion that price inflation will be coming down consistently and rapidly by you-name-it expert/pundit/talking head may prove to be an incorrect assumption.  And If that turns out to be the case – stock market pain is in its early innings.   I wish you well…

Ken Reinhart

Director, Market Research & Portfolio Analysis


H&UP’s is a quick summation of a rating system for SPX9 (abbreviation encompassing 9 Sectors of the S&P 500 with 107 sub-groups within those 9 sectors) that quickly references the percentage that is deemed healthy and higher (H&UP). This comes from the proprietary “V-NN” ranking system that is composed of 4 ratings which are “V-H-N-or NN”. A “V” or an “H” is a positive or constructive rank for said sector or sub-group within the sectors.

This commentary is presented only to provide perspectives on investment strategies and opportunities. The material contains opinions of the author, which are subject to markets change without notice. Statements concerning financial market trends are based on current market conditions which fluctuate. References to specific securities and issuers are for descriptive purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. There is no guarantee that any investment strategy will work under all market conditions. Each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. PERFORMANCE IS NOT GUARANTEED AND LOSSES CAN OCCUR WITH ANY INVESTMENT STRATEGY.

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