Posted by Jeffrey J. Roach, PhD, Chief Economist
Tuesday, August 29, 2023
- Despite a hawkish tone, Chairman Powell is in full-on risk management mode.
- Federal Reserve (Fed) officials are uncertain about the time it takes for tighter policy to flow through the economy.
- Fed funds are above inflation and unequivocally restrictive.
- Being data-dependent means the markets are right—the Fed will likely cut rates in 2024.
Chairman Powell closed out his speech at last week’s Jackson Hole Symposium with a whimsical, yet fitting analogy for setting monetary policy. He said the Fed is “navigating by the stars under cloudy skies.” The markets are getting comfortable with a Fed fully aware of a toolbox full of limitations. Monetary policy is oft considered a blunt tool since the fed funds target rate is one rate for 50 states, thousands of industries, and all ages. Therefore, policy must not be entered into lightly, and the fact that the Fed is talking about risk management provides some salve for investors increasingly confident the Fed won’t break something in their efforts to quell inflation.
Risk Management is Paramount
When it comes to hiking the fed funds rate, the Fed is currently very close to the place where the risks of doing too much are roughly in line with the risks of doing too little. One main reason for risk management is the lagged effects of monetary policy. Tightening credit conditions take time to filter through the economy, so that’s why policymakers are concerned about the unknown effects yet to emerge on the economy. The Fed is focusing on risk management now and carefully dissecting the data for any emerging economic cracks. One risk is the rising debt burden among consumers who hold balances on their credit cards.
The Fed is highly data dependent and will be ready to hold rates unchanged if the data clearly supports the notion that inflation is trending close to the 2% target. Our view is that the Fed is becoming even more data dependent, so this week of economic data will be especially important for asset allocators. As inflation pressures ease and the job market cools, investors could see more improvement in equities as markets look to 2024. Job growth in August might be the lowest monthly gain since 2020, but wages seem to remain hot.
Policy Gets More Restrictive When Inflation Falls
The Fed raised the fed funds rate by 525 basis points since early 2022, and as shown in the chart below, monetary policy is clearly restrictive and will continue to dampen economic activity and inflation.
As inflation falls, policy will get more restrictive as the gap widens between the fed funds rate (upper bound) and the core deflator, the Fed’s preferred inflation metric.
Investors should get better news later this week as the job market is expected to slow and inflation rates will likely cool. As the data supports a pause in Fed policy, markets should get a little more comfortable about heading into 2024. A recession could still emerge as consumers buckle under debt burdens and excess savings dry up, but a Fed sensitive to risk management might provide the salve necessary for more risk appetite.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.
Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks
References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.
Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.
All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.
Not Insured by FDIC/NCUA or Any Other Government Agency | Not Bank/Credit Union Deposits or Obligations | Not Bank/Credit Union Guaranteed | May Lose Value