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Will the FED Have to Return to Their Historical Interest Rate Policy Approach?

CAMS Weekly View from the Corner – Week ending 3/3/2023

March 6, 2023

We have all heard that the Federal Reserve, led by Chairman Powell, has raised interest rates far too high and is choking the life out of the economy.  Interestingly, to the degree the “choking the life out of the economy” is true (that’s a different discussion) the real metric they are interested in “choking out” is price inflation and that is certainly not gasping for air. We have certainly seen overall economic activity weaken and to be fair we have seen price pressures weaken if we qualify that with “kind of sort of weaken” when discussing price inflation broadly.  As we have shared throughout numerous editions there are a number of deeper level price inflation measures that have actually remained on-trend and have not weakened at all.  That’s important to keep in mind. Their trends remain fully intact and if we remove background narratives (which can create bias that said narrative is actual reality) that price inflation is a non-issue – think “the Fed has won the battle and should be pivoting to lowering interest rates soon” –  we can more clearly appreciate the steadfastness of underlying inflation. If we remove the pivoting hope/narrative and remain focused on the underlying issue (price inflation) we can see, regardless of the inflation measure we look at that it remains well north of the stated 2% inflation objective Chairman Powell and friends have relentlessly emphasized as their target.  This is a front-and-center problem in the economic landscape. Interestingly, as shared in a recent edition, as Chairman Powell consistently emphasizes the Fed’s steadfastness on fighting price inflation broad financial system participants (to include market participants) have been easing financial conditions since October.  This has held true up to current day even in light of recent price inflation data coming in higher than expected.  Simply said, it is as though financial system participants refuse to accept that we do have an inflation issue that has proven to be anything but a blip on the timeline.  Through the lens of the inflation issue a concern is:  Will easing financial conditions by financial system participants sow the seeds of unexpected on-going price inflation?  This while the Fed is pushing interest rates higher and simultaneously expecting said financial conditions to tighten and in so doing, relieve inflation pressures.  Something has to give as in either inflation reduces notably across the board soon or financial system participants reverse course and begin to tighten in conjunction with the Fed because, per the Fed’s messaging, they will not give up on the inflation fight. Importantly, through the lens of history, the Fed remains in easy mode (that may be hard to believe if your sense of history is the previous ten or twenty years) relative to their interest rate policies when factoring in price inflation.  Let’s break it down.

For a historical perspective the above chart dates back seven decades to the mid-1950’s.  There are two lines interacting with the blue line representing the Fed’s Federal Funds Rate (representing their interest rate policy setting stance) while the red line depicts the well recognized Consumer Price Index (CPI.)  Left to right the red circle and then the red box highlights decades of time whereby the Fed’s interest rate level (blue line) was customarily held higher than the red line which is the CPI. Our far right box depicts the previous couple of decades whereby the Fed had flipped the long held historical relationship to the point where it has become customary for the Fed to set their Funds Rate below the level of inflation.  Our red arrow highlights the extreme case of this where they held interest rates at 0% for years while inflation remained far north of 0%. Societal Life under the Past Fed Interest Rate/Inflation Rate Relationship Offering one angle of the societal backdrop under the long-held approach of setting interest rates higher than the inflation rate (1950’s – 2000 in above chart) the citizenry experienced interest rate offers for non-risk investments (think CD rates at local bank) at or higher than what the consumer within them was experiencing on the inflation front. A natural by-product of this interest rate/inflation rate relationship was that broad societal speculation was much less prevalent within the financial system. Keeping it simple, if the masses are incentivized to consider a non-risk rate of return that will simultaneously offer at least an attempt to keep their savings whole when including the inflation rate how many will check that box rather than speculating in X area of the financial system.  Importantly, this goes beyond the kneejerk thought of the stock market but goes throughout the entire financial system from raw land to housing to art to classic cars – you name it.  Underneath, well, deeply underneath the financial system’s easing of financial conditions since October is a (deeply) embedded collective speculative mindset.  This stems from many years (decades now) of Federal Reserve cheap money policies broadly speaking. More specifically and speaking to our above chart, the relationship of the Fed ending its long held stance of holding their Funds Rate higher than the inflation rate played a notable role in building the aforementioned speculative mindset.  The question in our time now is will this mindset and ensuing collective behavior from it need to be broken via instituting a policy approach of decades past as depicted in the above chart?  If so, oh-oh. This would mean interest rates go higher and will be held higher for longer than the often expressed “pivoting narrative” is offering and with this asset prices generally will feel the heat of the pivot narrative being rebranded to the “we were wrong” narrative. Bringing the Decade’s Long Storyline Together The bottom line is the Fed remains in “easy mode” relative to their interest rate policies when factoring in the inflation rate when viewed through a larger lens of history – think chart above. With this a deeply embedded speculative collective mindset exists and is showing itself, in particular since October, with the broad financial system easing financial conditions regardless of Chairman Powell’s drumbeat emphasis that price inflation is a real issue and they as an entity are quite serious about fighting it. As a result of the steadfast price inflation issue while simultaneously the financial system eases financial conditions Powell and friends may have to raise interest rates higher for longer than the often repeated pivoting narrative is offering.  If so, we may be seeing the decades past relationship depicted in our left to right circle/box become policy again which will offer quite a challenge to the collective speculative mindset with a logical follow-on of pressuring general asset prices downstream. The antidote to this:  Price inflation needs to notably recede soon and if not then financial system participants will need to join the Fed in tightening financial conditions to collectively combat inflation lest the Fed is forced to raise rates higher than what is currently expected. I wish you well…

Ken Reinhart

Director, Market Research & Portfolio Analysis

Footnote:

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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