Visualize a cloudless, cerulean sky with the Flying Wallendas on a tightrope spanning Niagara Falls. On one side are the frigid waters of interest rate hikes to slow the economy; on the other, the churning vortex of inflation making passage very difficult. Jerome Powell, the Fed Chairman, is performing a somewhat similar, precarious feat.
He must maintain a delicate balance to avoid the economy falling into either disaster. If you prefer Greek mythology, he is between Scylla and Charybdis.
Powell, expressionless with eyes fixed on the camera, spoke firmly and with the clarity of Waterford crystal. As any tightrope walker must do, he shifted his weight to the side of price stability and higher interest rates. He remains more hawkish than dovish. Since demand has to be moderated, he said, the next move by the Fed will be “restrictive,” adding that “Another unusually large increase could be appropriate at the next meeting.” While Powell was non-committal, we believe he is strongly implying that the Fed will raise rates by 0.75% at its September meeting. This will likely have a dampening effect on stock prices.
He also addressed the psychology of inflation, which we have discussed in several newsletters. If the public thinks inflation will remain high in the future, they may purchase goods and services now, further raising prices. If corporate America thinks inflation and interest rates will remain high, they will wait for a slowdown before lowering prices, while not adding to their workforce. Inflation is partly a self-filling prophesy; “inflation feeds on itself.”
There was no hint of a recessionary threat in his remarks; in fact, he stated the economy has an underlying strength. To lower inflation, however, “We will have a sustained period of below-trend growth,” as well as higher unemployment rates. Inflation, he declared, causes “pain,” a word seldom heard from Fed Chairs, reinforcing his commitment to curb it through restraint and discipline.
There have been this quarter signs that inflation has mitigated moderately. The Personal Consumption Expenditures Price Index declined in July by 0.1% month-over-month, the first such decline since April 2020. The core PCE Index, which excludes volatile food and energy prices, rose 4.6% last month from a year earlier, after rising 4.8% in June.
The Consumer Price Index (CPI) rose in August by 0.4%.
The core CPI, excluding food and energy, also rose by 0.4%. Both readings are in line with economists’ projections.
The CPI has been showing higher inflation than the Personal Consumption Expenditures Index. Last month, for instance, CPI was running at an 8.5% annual pace after hitting a four-decade high 9.1% in June. One reason: The Labor Department’s index gives more weight to rents, which have soared this year. The Personal Consumption Expenditures (PCE) index is less well known than the Labor Department’s Consumer Price Index (CPI) but it is the Fed’s favorite inflation gauge. It allows the Fed to determine changes in consumer buying habits.
The Producer Price Index fell 0.5% in July, following advances of 1.0 % in June and 0.8% in May.
Gas prices have dropped every day for the past 74 days, as of the writing of this commentary. The Energy Index fell 4.6% in July, after rising 7.5% in June. On an annual basis, the Energy Index increased 32.9% for the 12 months ending in July, a smaller increase than the 41.6% rise for the 12 months ending in June.
Although inflation shows some signs of moderating, a CPI and PEC reading or two does not constitute a trend. Our research shows us that it takes time for the effects of interest rates to seep through the economy and consumer buying habits before it becomes apparent in lower prices and lower inflation. In the past, when Fed Chairs thought that inflation was curbed, they lowered interest rates, only to be hit by still higher inflation. We also believe that the Fed must trim its balance sheet and ramp up its quantitative tightening program. Interest rates by themselves may not be enough to curb inflation.
Financial commentators speculate almost daily on what type of landing the economy will have: hard, soft, bumpy, glide, helicopter. Our thoughts for a good landing put inflation in the 4% range, unemployment below 5%, and Fed interest rates at 4.5%. We continue to expect the course to be bumpy. Diversifying our holdings based on the underlying drivers of inflation risk remains at the top of the list. The recent summer rally is positive is meaningful from a historical standpoint, and we take some comfort in the past patterns of stock market recovery. A study conducted by 3Fourteen Research found 67% of rallies that advance by 10% following a 20% drawdown transform into full-fledged bull markets. Our playbook is unlikely to change. We will continue to diversify holdings based on the underlying drivers of company-specific performance in our stock strategies and remain cautious in our overall equity exposure throughout our ETF strategies. The key to success in this market climate is patience.