Fed Responds to Inflation Progress, Economic Resilience
Our Views
In our view, the markets overreacted to the change in the FOMC’s median expectations of rates by YE 2024, which shifted from 4.6% to 5.1%. Powell explained that stronger economic activity was behind that shift, and that while GDP is not part of the Fed’s mandate, the members wanted to see how GDP will affect inflation and labor markets. That’s actually a pretty logical reason for Fed funds to be higher and does not reflect a hawkish take by the FOMC, in my view. A hawkish take would have been remarks about Fed funds needing to stay high because of inflation persistence.
People think that higher yields mean P/E goes down, but that’s not necessarily true. Since 1930, a 4.5% US 10-year yield has not been a P/E killer. In fact, the “sweet spot” for P/E is 3.5% to 5.5% yields, which have seen an average P/E of ~20X. US yields below 3.5% are actually associated with lower P/E.
We continue to live in a “good news is bad news” type of world. Economic resilience has certainly created this “higher for longer” mentality. The Fed’s response yesterday was actually pretty important. They took back half of the cuts that were priced in for 2024. So I think clearly they wanted to send a message that the economy is stronger. They basically doubled the GDP quarter this year to 2.1%. And for next year, it’s up to 1.5%.
Meanwhile, Powell’s acknowledgement of uncertainty I think was interesting and actually gave him a fair amount of credibility. That’s good to see.
Powell noted that a government shutdown could slow the data that the Fed needs for the next meeting. That could be a problem since they want to be data-driven.
A government shutdown is not a full shutdown. They continue to fund essential operations like air-traffic controllers and the military. But I’m not sure that they can argue that it’s essential for the data people at the Department of Labor who collect and compile information on food prices and such to continue to work during the shutdown. So, depending on how long the shutdown lasts, it might be interesting to see how the FOMC, which has repeatedly said they’re data driven, responds. What do they do if there’s no data?
The dot plot and Fed Chair Jay Powell’s rhetoric collectively signal a “higher for longer” monetary stance. However, a closer look at the Fed’s economic projections reveals that the Federal Reserve Board anticipates a relatively soft landing. There seems to be a discrepancy between Powell’s comments and the Federal Reserve’s projections, and that could be the reason why (as of publication time) the Fed fund futures market has yet to fully price in an additional rate hike for this year.
The stakes for upcoming inflation data have undoubtedly risen, particularly given the recent surge in gas prices. This increase has psychologically impacted the public, possibly explaining why Powell has adopted a decidedly hawkish tone in his recent communications.
Throughout 2023 and going into the September 20, 2023 FOMC meeting, our view has continued to be that real-time data shows that inflation is on a glide path down, that the lagging metrics used to calculate inflation indicators would come to reflect that, and that when – not if – this happened, the Fed’s response would provide a powerful boost to markets. In recent months, we had begun to see this, with CPI, PPI, and PCE readings having softened through the summer.
To a certain extent, FOMC members noticed. The group’s median estimates for 2023 Core PCE fell slightly between June and September. Fed Chair Jerome Powell also acknowledged this in his press conference, confirming the “good inflation readings that we've been seeing for the last three months.” He added, “We’re seeing progress [on the inflation fight] and we welcome that,” further noting that “longer-term inflation expectations appear to remain well anchored as reflected in a broad range of surveys of households, businesses and forecasters as well as measures from financial markets.”
To that end, the FOMC paused its hikes, keeping the target range unchanged. This was not a surprise: Fundstrat’s Head of Research Tom Lee called the decision a “fait accompli” on Tuesday evening, and the CME FedWatch tool on Tuesday showed a similar view by markets.
Still, our Washington Policy Strategist Tom Block observed, “I think it is a big deal that while Powell was able to hammer out a unanimous decision this week.” Block found this noteworthy because the minutes from the previous FOMC meeting had shown, in his view, that “the unanimity of some past meetings was slipping [with] some Members [...] turning more dovish.”
Nevertheless, as Lee put it, what mattered on Wednesday was “the Fed’s views around the path of future hikes, the future neutral rate and general assessment on inflation.” Markets viewed the dot plot and Summary Economic Projections (SEP) released after the meeting as a shift toward the “higher for longer” camp. A majority of members indicated that they expect one more hike before the end of 2023. The group also shifted its median rate expectations for YE 2024 upwards.
Powell said this had more to do with “economic activity [that] has been stronger than we expected'' than with inflation-data trends. Recall that according to the minutes from the June meeting, “a number of participants judged that, with the stance of monetary policy in restrictive territory, risks to the achievement of the Committee’s goals had become more two sided, and it was important that the Committee’s decisions balance the risk of an inadvertent overtightening of policy against the cost of an insufficient tightening." But with the latest SEP showing increased expectations for 2023 and 2024 GDP and lowered expectations for unemployment, the balance of risks appears to have shifted.
Lee said that it makes sense that the SEP forecast went up. He also agreed with the market’s take that a “higher for longer” approach raises the risk for an economic hard landing. But as he points out, Powell admitted the Fed did not decide to take this approach because inflation was up, but because Fed members see the unexpectedly resilient economy as able to withstand a more cautious approach to ending the rate-hike cycle. Given that, his view is that the hawkish market response was an overreaction.
Lee further pointed out that the dot plot showed that some members who in June had expected more than one additional hike left for 2023 had since revised their expectations downwards. “We actually saw some hawkish moves removed from 2023,” Lee noted.
It is important to remember that Powell told reporters, “We're fairly close, we think, to where we need to get.”
