What’s the End Game for the Fed?

The Fed hiked rates by 0.75%, as expected, in its September meeting. Fine. The market all but rolled out the red carpet for another jumbo hike (jumbo because a normal hike is 0.25%). The futures market priced in about an 80% probability that it would happen before it was announced. 

The July hike was accompanied by some soft language that continued a rally. Jerome Powell (the Fed Chair) said we were close to “neutral”, meaning the Fed was quite possibly done hiking for the time being. Their own forecasts had a pause and a relatively quick “pivot” to cut rates again. Accommodative financial conditions are fuel to inflation’s fire. It would’ve worked if inflation was coming down.

But August brought a hot inflation reading with CPI registering 8.3%, even with gas prices coming down, this is unacceptably high for Americans. I’ve mentioned CPI being not the preferred measurement, and though imperfect, it is still useful to measure where inflation has been and where it could be going. The high inflation reading was a mixed bag. The trend of inflation is still going down, but inflation is spreading to other parts of the economy. The most notable increased in utilities, which are electricity and natural gas. Americans are saving little at the pump but are paying more to keep their homes humming. 

Back to the September hike. The expected increase was already priced in, but the accompanying speech squashed any glimmer of a “pivot”. Powell came out strong and kept consistent with messaging. That message being inflation is the enemy and we’re going to make sure it’s not only dead but buried under a mountain of dirt. The growing chorus of a Fed mistake is growing with concerns that rate hikes are going too far, sending the economy into a deeper than necessary recession. 

Jerome Powell reiterated that inflation and inflation expectations need to come down. This will be accomplished by raising the unemployment rate and limiting wage increases. Inflation expectations are key and a major focus of Powell’s. When inflation isn’t top of mind for most Americans, he can consider his job mostly done. The thinking here is if expectations go down, actual inflation will soon follow. If businesses believe that inflation will go down, they’ll stop raising prices.

It's no coincidence that Powell’s speech was so forceful. This Fed has a tarnished reputation to repair. In 2021, they completely missed the warning signs and said inflation was “transitory”. Not to forget, I also said inflation should come down with time with news of the supply chain improving. Being behind the curve, Powell is trying to “front load” hikes to slow down the economy sooner. Rate hikes historically take 12-18 months to see any impact. If the act of hikes has a delay, Powell is doing everything he can to talk inflation down.

So far, it looks like all that talking is working, at least in the stock market. What do stock prices have to do with anything? There could be several impacts. The wealth effect could have downward pressure on spending as Americans don’t feel as wealthy, so belt tightening starts to happen. CEOs, whose compensation is heavily tied to stock performance, will start to look to reduce overhead. Not to mention borrowing costs have gone up sharply. Mortgage rates have jumped to over 6%. 

Home builders have slowed housing starts significantly. While this makes the housing supply worse, it does lower demand for lumber, copper, aluminum, appliances, etc. Homebuilders will eventually start again once construction costs normalize.

The Fed holds $2.7 trillion in mortgage assets. They have yet to sell any of these mortgages but the market already reacted before a single dollar was sold. This was by design. The Fed was very explicit with its plan, letting the market do the work. 

I think that’s where the Fed signaling stops. We won’t see any clues about a slowdown in the hike cycle. When it happens, the markets will rally. The question is when. Look for inflation readings to come down, especially PCE. 

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