Everything Looks Like a Nail

November 7, 2022

By now, we’re all aware the Federal Reserve’s Open Market Committee boosted its target rate by another 0.75% last week, the fourth such movement in its last four meetings.  There was no surprise in this announcement – various Fed officials telegraphed this message in the weeks leading up to the Wednesday release.

The surprises took place during Chair Powell’s post-meeting press conference. Many observers were expecting an acknowledgement of a ‘Fed Pivot’ to a more benign policy stance moving into 2023. No such luck, which explained the dramatic drop in stock and bond prices as the afternoon progressed.

Unsettling “Higher for Longer” Stance Perpetuates Unstable Markets

Specifically, Chair Powell indicated that the Fed’s terminal rate will be higher than previously indicated in the prior Summary of Economic Projections (commonly referred to as the ‘dot plot’). And, a policy stance of ‘higher for longer’, as Chair Powell stated, certainly narrows the runway for a soft landing.

A couple of points from this…  First, it’s well established that Fed actions operate with a lag. You’ve read in these comments before that when the Fed acts, its impacts are felt first in the financial markets (almost immediately), and then, sometime down the road, in the real world. We’ve seen what restrictive policies have done to stock and bond markets this year. And housing – which is obviously tightly connected to interest rates – is entering its own recession.

At the same time, Chair Powell noted that core economic activity remains strong. Specifically, he referenced there are still about two job openings for every person seeking employment. This is a significant part of the Fed’s rate calculus. Structural inflation will not abate until supply and demand for goods, services, and workers are brought into balance. 

How Deep Must the Nail Be Hammered?

Let’s think about this. The Fed can do nothing to improve supply chain movement, weather-related food price increases, or gasoline and home heating costs. All are outside its realm. What the Fed can do is affect demand. It does so by raising interest rates to the point where overall economic activity is curtailed. And, as Chair Powell implied, monetary policy is not restrictive if policy rates are below the core inflation rate – as they are even after Wednesday’s announcement. 

The logical (and unspoken) conclusion is that higher unemployment is an unwanted – but necessary – component of its efforts. It is difficult to see how the supply and demand for workers will become more balanced in the absence of a materially weaker economic environment.

Thus, the title of this Commentary.  The Fed’s primary tool is a hammer, and the economy is the nail.  The open question is how much further the nail needs to be driven.  We believe the bulk of the Fed’s work has been done, but the finishing work is still an unknown distance down the road. 

This will be my last Commentary before the holiday season, so I’ll close by wishing all happy and healthy gatherings with friends, family and loved ones.  This has been a challenging year, and we all look forward to 2023.  Your success – in good times and bad – matters to us.   Contact us today to see how your portfolio can be built for long-term success.