Chairman Powell, as we expected signalled the Federal Reserve will continue to hike rates until inflation is fully tamed.
His exact words, ‘We will keep at it until we are confident the job is done.’
The market apparently, was looking for something a little more neutral? After all the talk of a ‘pause’ and ‘pivot', none of which ever made any sense with a Fed that has said several times it will keep hiking rates even if it means some economic pain, we are back to square one with a Fed outlook to keep tightening.
The Fed was always going to keep raising rates aggressively, but the market decided to price in a slowing in hikes, and even a reversal?
So where does that leave us with the outlook for the stock market for the rest of this year, and into 2023?
The US and global economies are in far worse condition than anyone expected, and are struggling to find a footing or some kind of stabilisation. In this environment, the Federal Reserve will likely raise rates toward 4.5%, 5.5%.
This is highly problematic, but the Fed in its mind, is triaging the situation. It cannot immediately grasp or deal with all the downward factors at play on the economy, and so is simplistically focussed on inflation first. The Fed is reading from the 1960s playbook, which was when you have a booming economy and this is driving high inflation, you need to tap on the breaks for the economy by raising rates.
There are several flaws in this approach.
Firstly, interest rates were left at all time crisis lows for far too long and un-necesarily, means you can have a year of rate hikes before you begin to have any impact on the real economy. Apart from mortgage stress, which has been created by rates too low for too long in both the US and Australia. Encouraging greater risk taking than many households can manage.
Secondly, and not to put too fine appoint on it, the US economy is rapidly slowing. Not booming, as in previous central bank inflation fighting periods. This is a new economic experience, and it probably requires a lot more 'look out the window' at the real world thinking, than just a repeat of what central bankers did last century?
As we suggested mid last year, the Fed was making a critical error in not beginning to raise rates gently at that time. For not to respond to the strong Covid economic recovery and growing inflation at the time, could only result in the bank following up that historic blunder, with a too late, too aggressive rate hike cycle further down the track.
The Fed needs to understand it has made a huge blunder and is now wrong footed by the contemporary situation. Only then, can the Fed begin to plot a better course than aggressive hikes during an economic slow-down.
The solution probably looks more like, we got it wrong, so let’s get rates quickly back to neutral. Then we can more fully consider if restrictive rate settings are appropriate in a weak economy with an inflation that is predominantly supply driven.
It may well be the case that this is not a form of inflation that will respond very much at all to higher interest rates? Therefore, why double up the already dampening forces of stepped up energy and food prices, that had little to do with economic growth levels?
A quick Fed response to a reasonable neutral, then a more nuanced approach from there, is probably the best way to follow up last year’s Fed policy settings disaster.
Rather than a overly-simplistic last century war on inflation approach.
The stock market wanted, for reasons of hope more than anything else, to look ahead to a renewed period of strength. The market actually priced in bullish parameters that have little probability of fruition.
Does this mean then, that stocks have to go to new lows for the year? To more fully reflect the odd reality of slowing growth and interest rate increases simultaneously.
The short answer is yes.
The economic un-certainty has only increased, and the Fed is more hawkish than ever. It would seem that a more accurate fundamental pricing of the stock market is 10% to 20% lower than here. Perhaps, even lower than that.
Clifford Bennett
ACY Securities Chief Economist. The view expressed within this document are solely that of Clifford Bennett’s and do not represent the views of ACY Securities.
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