Can the Fed Adjust its Inflation Target and Adopt a New Normal?

Can the Fed Adjust its Inflation Target and Adopt a New Normal?

April 12, 2023

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This week marks the first week of earnings reports for Q1 of this year. These are clearly important numbers as they are a reflection of the economic prosperity of companies individually. It will be interesting to see if the numbers are an opportunity for companies to air all their dirty laundry or if it provides us an opportunity to separate the low debt, low employee count companies that are not as greatly affected by higher interest rates from those that have costly amounts of debt and increasing labor expenses. Along with earnings, inflation measures will be coming in with last month's CPI (measure of consumer prices) on Wednesday and PPI (measure of producer prices) on Thursday. Since plenty of latitude is probably going to be given to most companies, there still is the elephant in the room known as interest rates. As for small business hiring intentions, this is how it looks currently:

I suppose that the Federal Reserve Chairman, Jerome Powell is OK with how his credit-tightening cycle is going. After all, you don't jack up the federal-funds rate from 0.08% to 4.83% in 12 months without knowing that you will break some eggs, particularly those of vulnerable financial institutions. The health of our financial system was once again questioned in the last month much like it was in the Great Financial Crisis of 08-09. To this end, this past weekend had some extremely interesting articles on the subject. There were basically three articles that you should really take the time to read:

  1. Fed Move Came Down To Wire on 'Rough Weekend.' The Saturday Wall Street Journal. This is a particularly interesting article as it gives some great detail on how different arms of the US Government and the Fed worked together on the Silicon Valley Bank run and handled the problem. A great read for sure!
  2. The Man Who Saw the Economic Crises Coming- This was also in the Saturday Journal in the Opinion section. This is an article about Paul Singer, 78. He is the founder of Elliot Management. He warned of the subprime issue in 08, Dodd-Frank in 2010, and inflation in 2020. Mr. Singer's comments I found quite interesting. 
  3. Memo to the Fed: Take a Tip From Hamilton- this is last weekend's Q&A interview with Mohamed El-Erian in Barron's. Again, very good information on dealing with the subtle balance between raising rates enough to stifle inflation, but not too much so as to throw the economy into recession. 

I would highly recommend reading all three. In the interview with El-Erian, he was asked what the difference is now, between the Great Financial Crisis of 08-09 and today. He said, "This banking turmoil is very different. In terms of the degree of severity, it is probably 1/10th of what we felt in 2008. Next, you could see the first signs of economic contagion in restricted bank lending to the real economy by community and regional banks that have lost deposits." When asked how inflation affects the economic outlook, he responded that the Fed incorrectly stated that inflation was transitory. It was clearly far more entrenched than transitory throughout 2021. Even after the Fed admitted that it wasn't transitory, they still didn't do anything about it and kept pumping money until March of 2022. So where are we now? To answer this, I want to show the current interest rate picture of the progression of US 10-year maturity Treasuries. As can be seen, these longer rates have been falling and last week traded at a lower interest rate than they were in September. I take this as a positive as it should be reflective of the interest rate hikes doing what they are intended to do- slow the economy. 

If one is to next look at the stock market in terms of the S&P 500 index, it can be seen that it bottomed in October, just after the 10-year interest rate peaked, and has been building a base since then. 

So now we are posed with the most difficult question; how much further should the Fed need to raise rates? It's tricky. We are at a point (as evidenced by banks starting to crack) where everything they do has collateral damage and unintended consequences. They have moved rates so much, so fast, that as stated above, eggs are starting to crack. This response, in retrospect, will go down in history as one of the biggest policy mistakes by the Federal Reserve because it is no longer just an issue of inflation versus growth but now inflation versus financial stability. It is beginning to appear that the “least bad” option now consists of holding off on interest-rate hikes and being honest with the market about where interest rates are going. Their 2% inflation target is probably just too rigid given the amount of capital still sitting on the sidelines. If they can get it down to 3-4% and hold it there, then maybe the Fed could adjust their inflation target and the economy doesn't dive into recession. Look below at the inflation measures of CPI:

If the Fed can back off on the hikes for a bit and allow the economy some time to adapt to the "New Normal," then companies could conceivably continue their economic expansion should the economy not recess. See the chart of theses outcomes below:

In closing, I want to share the US Presidential Cycle chart updated to last week. As can be seen, if history is any precedent, and if we don't go into a full-blown recession, the rest of this year could be quite good. 

This week's note is a bit more academic, but I felt that a clear understanding of the precarious situation we are now in is ultimately the most important point to go over. I certainly hope that you enjoy our perspective, and we welcome any questions you may have. 

 

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