Confused and Afraid

Every economic recession in the entire post war period has been precipitated by the efforts of the Federal Reserve Board to curb and reverse accelerating inflation in the U.S. Historically, the Fed has been behind the curve during every period of economic overheating because the FOMC has always followed rising interest rates instead of getting out in front of them. As a result, in every instance, by the time monetary policy becomes restrictive the forces of inflation have become sufficiently entrenched so as to require an economic recession to break the momentum. Thus, the economy has never enjoyed a so-called soft landing.

Ironically, in the current situation, the FOMC claims that by “normalizing” interest rates before inflation builds up a head of steam, it will insure a long running economic expansion. Unfortunately, the FOMC’s focus on the currently low (3.7%) rate of unemployment has left it oblivious to a number of forces that are not only suppressing inflation, but in addition are already slowing the economy’s growth rate.

First of all, there is no such thing as wage push inflation. That is a totally fallacious concept. Inflation is always a monetary phenomenon, i.e. too much money chasing too few goods and services. Over the past year, Broad Money Supply (M2) has expanded at a 3.8% pace, well under the growth rate of nominal GDP at 5% plus. Together with the gradual shrinking of the Fed’s balance sheet, the increases in the Federal Funds rate, and tepid loan demand have all contributed to what is a mild liquidity squeeze, hardly a backdrop for accelerating inflation. Moreover, inflation is being restrained by various structural factors, including globalization, technological advances, intense competition by various disruptors, demographic factors and a strong U.S. Dollar, the latter in part a function of a rising Federal Funds rate.

Moreover, the economy is already slowing, e.g. housing and autos. The Trump tariffs are raising input costs in some industries, which will either be absorbed by companies, thereby inhibiting their growth or offset by raising taxes on consumers, neither of which can be constrained by a tighter monetary policy. An array of data from both industrialized and emerging economies indicate a global slowdown is underway. Of particular importance to the U.S. economy is the pronounced slowdown in China.

It would seem that today’s FOMC members believe they have learned from the Fed’s historical mistakes, but they are failing to understand that, “This time it really is different.” If the Fed continues on its current rate hiking path in a desire to build up the weaponry with which to combat the next cyclical downturn, it will only hasten its arrival.

Normal Market Correction or Worse?

We recently responded to a survey put forth by one of the major investment firms inquiring of institutional investors their views toward the economy, the stock market in general, favored industry groups, etc.  There was a section in which respondents were asked to check off the risks facing stock prices in the months ahead.  One of the questions posed was whether or not there was risk of a miscalculation by the Federal Reserve's FOMC, to the extent that premature and too rapid tightening of monetary policy could possibly trigger a recession and a bear market in equities.  At the time, our answer discounted this threat, as we believed that the economy is expanding at a healthy, non-inflationary pace, and that corporate profits would continue their strong uptrend.  Moreover, we believe that equity valuations, while pretty full, are not anywhere near dangerous or bubble territory.  The twelve-month forward P/E of the S&P 500 Stock Index is between 16 and 17.

Admittedly, there are some noticeable soft spots in the economy.  Residential construction has clearly slowed and is no longer a meaningful growth driver.  Automobile sales have flattened out.  Many industrial companies have noted softening demand, and/or higher input costs, often as a result of the tariffs imposed by the Trump Administration, including those imposed on steel and aluminum imports.  To be sure, there has been a modest increase in the rate of inflation, but structural factors, including intense competition, globalization, technological advances and, to some extent, demographics, have all kept the inflation rate from accelerating.  Modest paced money supply growth and bank lending do not appear to be fueling a general rise in the overall price level.

So, it was more than a little surprising, a week or so ago, when Jerome Powell, the recently appointed chairman of the Federal Reserve Board, enthusiastically proclaimed the strength of the economy and suggested that the Fed's target for the Federal Funds Rate might be allowed to overshoot the so-called neutral rate, currently estimated at about 3%, compared with the current 2.0%-2.25% target range currently in effect.  Admittedly, over the past half-century, the Fed has often fallen behind the curve as it attempts to maintain a balance between inflation and full employment.  Each time, as inflation has accelerated, the Fed has been forced to respond too aggressively, and in doing so it has caused the economy to slide into recession.  Mr. Powell seems obsessed by today's 3.7% unemployment rate, the lowest in nearly half a century.  Clearly, this is a sign of a strong economy, but when the three-month moving average of job growth is nearly 200,000, while only about one-third of that pace is required to absorb new entrants into the labor force, it is clear that previously unemployed workers are re-entering the job market and finding work.  It is impossible, at this time, to know how much further that trend can continue.

Nonetheless, Powell's comments, coupled with heavy Treasury financing, have unnerved equity investors, and as both the 10-year and 2-year Treasury yields have risen, stock prices have declined sharply in the first ten days of October.  At this writing, the S&P 500 is down nearly 3% so far in October.  The Index has broken below its 50-day moving average line at 2880, and is approaching the 100-day moving average at 2823.  For perspective, the 200-day moving average is at 2766.  A break below that level would probably signal the onset of a bear market.  The acceleration in the market's decline is the result of liquidation by a broad array of ETFs.  As we have noted in past memos, these vehicles which are essentially open-ended mutual funds that trade all day, instead of only at each day's closing prices, are essentially weapons of mass destruction, which never should have been permitted to exist.

As in every stock market cycle, the end comes when financial market liquidity becomes too scarce.  Typically, this occurs when the need to finance inflation runs up against monetary policy which is draining liquidity.  Currently, there is no need for the Fed to crush the economy in order to bring inflation under control.  One can only hope that the history of Federal Reserve policy changes is not repeated anytime soon.