Don’t fight the Fed

The adage goes, “don’t fight the Fed.”

In bull market runs, investors often repeat the “don’t fight the Fed” phrase to justify market run-ups that defy economic fundamentals. Price-to-earnings ratios out of line with, well, reality? The Fed “has the market’s back,” people say. 

But, since mid-June, investors seem to be fighting against central banks. Oddly, despite alarmingly high inflation and Fed officials hellbent on taming prices, bond yields, credit spreads, and equities have all rallied!  

Federal Reserve building.
The Marriner S. Eccles Federal Reserve building

Bloomberg News

In conversations with colleagues and clients, the justification for the recent run-up in risk rests on three factors:

  • Inflation shows signs of waning given the move in commodity prices since mid-June.
  • Due to the inflation decline, the Fed will do less hiking and maybe even pivot to cuts next year.
  • At the same time, a soft landing seems more likely (“look at the strength in the labor market!”). 

In short, a less aggressive Fed, softening inflation pressures, and the U.S. economy avoiding a downturn created the recipe for the risk rally in recent months. 

We have four problems with this “Goldilocks narrative.” 

First, inflation may have peaked, but we doubt core measures of inflation will tumble back anywhere near 2% soon. Even if energy prices continue to plunge, core (ex-food, ex-energy) costs show few signs of retreating, meaning the U.S. could still face 4% to 5% year-over-year “underlying” inflation into 2023. We hope we’re wrong in our inflation forecast, but as it stands, neither consumers nor policymakers will be satisfied with 4% to 5% inflation. 

St. Louis Fed President Bullard seems to agree with us, saying that “inflation has continued to broaden out and doesn’t look like it’s turning the corner, at least based on the evidence we have today.”  

Second, one question we encounter in conversations with colleagues is whether central bankers are “truly committed” to bringing inflation down.

We’re neither psychologists nor mind readers, but we suggest taking policymakers at their word until the inflation story changes. Unconvinced, one astute colleague responded with a question: “If the Fed had to choose between an unemployment rate two percentage points higher (i.e., 5.5% versus the 3.5% rate as of July) to achieve 2.5% core inflation in a reasonable timeframe, would they?”

Our response: absolutely, yes. Policymakers hope they don’t have to induce a two percentage point rise in the unemployment rate, but we think they would gladly take the policy option if prices stabilized quickly. 

A far worse outcome for central banks would be another few quarters of “sticky” prices. Richmond Fed President Barkin opined that “there is a path to getting inflation under control. But a recession could happen in the process.”

We understand investors’ skepticism, though.

Given nearly four decades of central banks prioritizing growth over inflation, the concept of sacrificing growth to wring out inflation is a foreign one.

In those four decades, central bankers did not have to deal with inflation expectations becoming “unanchored” from their 2% target.

The Fed had the opposite problem with inflation too low. We think investors may be ignoring the clear messaging from policymakers. We’ll hear more from global central bankers this week as policymakers assemble in Jackson Hole. Tread carefully.

Third, while we continue to hope/pray/cheer for a soft landing, we can’t ignore the mounting evidence of risks to the downside.

We’ve been warning about it for months, but the U.S. housing market is already in a recession. And evidence from the broader set of leading indicators doesn’t inspire confidence, as we highlighted in last week’s Chart of the Week.

As for the retort that the “labor market is strong,” we have three replies — first, labor lags. Second, job openings have plunged since spring. Historically, a job openings decline precedes an unemployment rate rise. And third, continued strength in the labor market (low unemployment, fast wage growth) will only encourage central banks to keep hiking.

Finally, and disconcertingly, most discussions with colleagues on the soft-landing scenario start and stop with the U.S. Are we to ignore the risk that the U.K. and euro area soon enter prolonged recessions and China fails to reflate? In that scenario, continued U.S. dollar strength will feedback into even weaker global activity. 

Bottomline: in recent weeks, the allure of a Goldilocks scenario has ensnared investors. But maybe the simple advice still applies: don’t fight the Fed?


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