“[T]he big elephant in the room is the Fed.”
Chief Economist and Strategist, Gluskin Sheff + Associates
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This week the Federal Reserve Bank of Kansas City is hosting its annual Economic Policy Symposium in Jackson Hole, Wyoming and a number of Fed officials have commented on “inflation.” Why is targeting inflation so important? Because rising inflationary pressures will cause the Federal Reserve to raise interest rates and such periods tend to prove challenging for the stock and bond markets.
In May, I shared the following on Fed tightening from David Rosenberg at the 2017 Strategic Investment Conference:
- [T]here’s never been a Fed tightening cycle that did not expose and expunge the bubble of the day, whether that’s in subprime autos, commercial real estate, leverage ETFs, take your pick.
- When the Fed is raising interest rates, these tightening cycles always start off benign but they never finish benign.
- And to get a sense of history, there have been 13 Fed tightening cycles in the post-World War II era, 10 landed us in an outright recession that the economists didn’t see coming ‘til we were knee-deep in it.
- There’s never been a Fed tightening cycle that left the economy stronger than what it was when they started.
If you missed last week’s post “Doesn’t Matter, Doesn’t Matter, Matters,” I shared my notes from a recent Bloomberg interview with Ray Dalio. There is an equilibrium in the capital market’s system where cash yields less than bonds and bonds have a lower return than stocks. There is an equilibrium that keeps working itself through the system; and monetary and fiscal policy are the tools we use as we work through short-term and long-term debt cycles.
So what our elected officials do in regards to fiscal policy (tax cuts and infrastructure spending are good and tariffs and trade restrictions are bad) and what the Fed does in regards to monetary policy (raise or lower interest rates, print and buy securities (“QE”) or unwind its balance sheet (“QT”)) impacts the economy and the markets in a powerful way.
How does this play out? We don’t yet know. Policymakers and central bankers will determine if the outcome will be beautiful or ugly. So we step forward and patiently watch.
Today I was a guest on Sirius XM’s “Behind the Markets” on Wharton’s Business Radio (Channel 111) with co-hosts Professor Jeremy Siegel and Jeremy D. Schwartz. Professor Siegel shared his outlook for equities, talked about valuations relative to low current interest rates and his belief that rates are headed lower. He sees another 10% to 15% advance likely for U.S. equities. He may be right.
Jeremy Schwartz added that we haven’t seen a period when both bonds and stocks sold off together in a material way. Meaning 2.16% 10-year Treasury yields just can’t help diversify a portfolio as they did in years past. The trip switch for the next risk event might just be inflation and rising rates.
You can find the Wharton Business Radio podcast interview here.
Congress established three key objectives for monetary policy in the Federal Reserve Act: maximizing employment, stabilizing prices, and moderating long-term interest rates. The first two objectives are sometimes referred to as the Federal Reserve’s dual mandate. With the employment objective met, we know that the Fed is focused on a 2% inflation target. (Rumor has it that the Fed would be happy with 3% inflation.)
We know what QE and zero interest rate policy has done for asset prices. Asset prices have inflated beautifully since the great recession. In simple terms, lowering interest rates has been good for stocks and bond returns. We are in a tightening cycle (Fed raising interest rates) that began in December 2015. Raising interest rates is generally bad for asset prices, as Dalio explained last week.
So it’s complicated, but there are important indicators we can watch. Since the Fed is targeting inflation, we can watch inflation to help us gauge their next move. My favorite inflation chart comes from Ned Davis Research (NDR). It is a model designed to signal inflation.
Here is how you read the chart:
- NDR’s Inflation Timing Model consists of 22 indicators that primarily measure the various rates of change of such indicators as commodity prices, consumer prices, producer prices, and industrial production.
- The model totals all the indicator readings and provides a score ranging from +22 (strong inflationary pressures) to -22 (strong disinflationary pressures).
- High inflationary pressures are signaled when the model rises to +6 or above. Low inflationary pressures are indicated when the model falls to zero or less.
- The bottom section (red line) details the model’s past and current reading of “5” as of 7-31-2017.
- NDR shows that economic growth, as measured by GDP, is stronger when the signal rises to +6 or above and slower when the signal falls to 0 or less.
I don’t use this indicator to tell me what GDP will be; I use it simply to measure inflationary pressures to determine what the Fed is likely to do. If there are high inflationary pressures, then they are likely to raise rates. If low, they will likely sit tight or lower rates. And since we are in a global economy and the U.S. is a significant part of global trade, I believe we can gain a lot by watching this chart.
Bottom line: right now it is telling us that inflationary pressures have rolled over from “High Inflationary Pressures” to the “Neutral Zone” (bottom section of chart, red line far right). However, the active signal, in place since mid-2016, is forecasting “Rising Inflation Rates.” This will likely keep the Fed on hold but leaning to the next rate increase in December. Stay tuned. I’ll continue to share this chart with you from time to time.
My overall two cents:
- The Fed is wed to the Phillips Curve. That’s why they’re raising interest rates and that’s where the policy mistakes that we’ve seen time and again is going to occur.
- We basically have never seen a situation going into a recession where measured rates of inflation and measured rates of nominal GDP growth were as low as they are today in any other prior situation.
- 10 of the 13 Fed tightening cycles since WWII have landed us in recession. Three have been soft landings. Global debt-to-GDP exceeds 325%. It’s 250% in the U.S.
- And it’s not just the Fed. We must consider what the central bankers in Europe and Japan are doing as well. It will show up in inflation. We need to keep our eyes on global capital flows.
The NDR Inflation Signal chart is a good tool. You can see what the Fed is looking at and why they began to raise rates. I can’t get that stellar post-WWII Fed/recession track record out