A philosophical question about the Fed's 'mistake' 🤔
Plus a charted review of the macro crosscurrents 🔀
🌴 NOTE: TKer will be off on Sunday, April 9. The free weekly newsletter will return on April 16.
Stocks rallied last week, with the S&P 500 rising 3.5%. The index is now up 7% year to date, up 14.9% from its October 12 closing low of 3,577.03, and down 14.3% from its January 3, 2022 closing high of 4,796.56.
Much of the market volatility over the past year can be explained by the Federal Reserve’s ongoing fight to bring down inflation with increasingly tight monetary policy.
I’m not one to dwell on the past, but it’s become pretty commonplace for people to blast the Fed for getting monetary policy wrong from the perspective of inflation. Specifically, many point out that inflation has been stubbornly high because the central bank made a “mistake” by being too slow to remove stimulative monetary policy.
These critics aren’t necessarily wrong. But assuming the Fed did hit the brakes on the economy when inflation started heating up in 2021, where would we be today?
If such a move worked and inflation eased quickly, then it’s also unlikely the economy would be as strong as it is today. After all, tightening monetary policy is about cooling demand — and that means the labor market probably wouldn’t be as robust as it is today.
Would everyone be OK with that?
Remember, the number of people who’ve gotten jobs during this period of high inflation is massive. And the money earned by these newly employed people is helping to keep inflation high as they bring more demand into the economy.
As of February of this year, total payroll employment was at a record 155 million. This metric didn’t return to its pre-pandemic level of 152 million until June of 2022.*
Meanwhile, inflation became particularly alarming back in June 2021, when the consumer price index surged above 5% for the first time since 2008. At that time, total payroll employment was much lower at 147 million.
Similarly, as of February, the unemployment rate was a very low 3.6%. It didn’t initally fall back to the pre-pandemic level of 3.5% until July 2022. In June 2021 when inflation was setting off alarms, it was elevated at 5.9%.
To be clear: This is a discussion about counterfactuals, which means there’s no way to know exactly how things would’ve unfolded under alternative scenarios.
But it’s not unreasonable to imagine a world where inflation was closer to the Fed’s target 2% rate today because the central bank acted quickly to rein in demand. This is what the Fed’s critics would argue could’ve happened.
However, it’s very hard to imagine achieving this without lower employment. Perhaps payroll employment would be above 147 million and the unemployment rate would be below 5.9%. But it’s hard to see the figures being very close to the 155 million and 3.6% levels we enjoy today.
So what’s worse: High inflation or high unemployment? 🤔
This is the type of trade-off that’s worthy of philosophical inquiry: Is it better to have moderate inflation with 147 million people employed as 8 million struggle with joblessness? Or is it better to have 155 million employed people share in the struggle with high inflation?
I don’t know how to answer these questions. (Though I’m eager to read your thoughts in the comments section!)
One of the reasons why I raise these questions now is because I was struck by Sen. Elizabeth Warren’s comments on March 7 to Fed Chair Jerome Powell during his appearance before the Senate Banking Committee.
Warren pointed out that the Fed’s own projections at the time assumed the unemployment rate would climb to 4.6% by the end of the year, which she said could mean two million people would have to lose their jobs. It was a jarring yet fair observation.
But again, I can’t help but think of how this scenario would compare to alternative scenarios. Would it have been better if employment levels just never got as strong as they are today? Two million jobs were created over the past six months alone. Is it better to have never hired those two million people? Or is it better to hire two million people and then layoff two million over a matter of months?
To be clear, the economy isn’t so simple such that we should only consider the binary outcomes offered above.
All I’m suggesting is that if you want to argue that the Fed was wrong in how it implemented monetary policy, then you are also implying that it was a mistake to foster an environment that led to the creation of millions of jobs over the past two years.
All that said, all eyes are once again on the monthly jobs report, which will be released on Friday at 8:30 a.m. ET.
* An earlier version of this piece said total payroll employment “didn’t return to its pre-pandemic level of 152 billion until June of 2022.“ This has been corrected.
Related from TKer:
The complicated mess of the markets and economy, explained 🧩
Reviewing the macro crosscurrents 🔀
There were a few notable data points from last week to consider:
🎈 Inflation cools. The personal consumption expenditures (PCE) price index in February was up 5.0% from a year ago, down from the 5.3% increase in January. The core PCE price index — the Federal Reserve’s preferred measure of inflation — was up 4.6% during the month after coming in at 4.7% higher in the prior month.
On a month-over-month basis, core PCE was up 0.3% in February. This was down from the 0.5% rate in January. If you annualized the three-month trend in the monthly figures, core PCE is rising at a 4.9% rate.
The bottom line is that while inflation rates have been trending lower, they continue to be above the Federal Reserve’s target rate of 2%. For more on the implications of cooling inflation, read: The bullish 'goldilocks' soft landing scenario that everyone wants 😀.
🛍️ Consumer spending is up. Personal consumption expenditures rose 0.2% in February.
Adjusted for inflation, real spending was down 0.1% during the period.
The bottom line: Consumer continue to spend at record levels. For more on consumer strength, read: 9 reasons to be optimistic about the economy and markets 💪.
🏠 Home prices cool. According to the S&P CoreLogic Case-Shiller index, home prices fell 0.5% month-over-month in January, the seventh consecutive month of declines. From SPDJI’s Craig Lazzara: “Financial news this month has been dominated by ructions in the commercial banking industry, as some institutions’ risk management functions proved unequal to the rising level of interest rates. Despite this, the Federal Reserve remains focused on its inflation-reduction targets, which suggest that rates may remain elevated in the near-term. Mortgage financing and the prospect of economic weakness are therefore likely to remain a headwind for housing prices for at least the next several months.“
For more on the cooling housing market, read: The U.S. housing market has gone cold 🥶
🏢 Offices are half empty. From Kastle Systems: “Office occupancy rose more than a point last week to 48.4%, according to the 10-city Back to Work Barometer.“
Fridays are the emptiest: “The daily high was Tuesday at 57.9% and the low was Friday at 31.3% occupancy.“
For more on empty offices, read: This stat about offices reminds us things are far from normal 🏢
💼 Unemployment claims remain low. Initial claims for unemployment benefits — the most up-to-date of the major labor market stats — climbed to 198,000 during the week ending March 25, up from 191,000 the week prior. While the number is up from its six-decade low of 166,000 in March 2022, it remains near levels seen during periods of economic expansion.
For more on low unemployment, read: The labor market is simultaneously hot 🔥, cooling 🧊, and kinda problematic 😵💫.
👍 Consumer confidence improves. From The Conference Board: “Driven by an uptick in expectations, consumer confidence improved somewhat in March, but remains below the average level seen in 2022 (104.5). The gain reflects an improved outlook for consumers under 55 years of age and for households earning $50,000 and over… While consumers feel a bit more confident about what’s ahead, they are slightly less optimistic about the current landscape. he share of consumers saying jobs are ‘plentiful’ fell, while the share of those saying jobs are ‘not so plentiful’ rose. The latest results also reveal that their expectations of inflation over the next 12 months remains elevated—at 6.3%…”
💸 Consumers plan to less on stuff they don’t need. From The Conference Board: “…consumers plan to spend less on highly discretionary categories such as playing the lottery, visiting amusement parks, going to the movies, personal lodging, and dining. However, they say they will spend more on less discretionary categories such as health care, home or auto maintenance and repair, and economical entertainment options such as streaming. Spending on personal care, pet care, and financial services such as tax preparation is also likely to be maintained.”
💸 Small bank deposit outflows stablize. Here’s JPMorgan on the Fed’s recent H.8 report: “Deposits at small banks (all those except the 25 largest) edged up $6 billion in the week ending March 22. This is a huge improvement over the $196 billion deposit flight in the prior week. Large banks (which includes a bank assisted by an industry consortium) saw deposits decline $90 billion in the latest week, more than reversing the $67 billion of deposit inflows the prior week.“
For more on what’s going on at the banks, read: As if the economic outlook weren't already hard to predict... 🤦🏻♂️; Same destination, but now a more treacherous path 🚧; and A few thoughts on the Silicon Valley Bank failure... 🏦.
📈 Every U.S. state is growing. From the Philly Fed’s State Coincident Indexesreport: "Over the past three months, the indexes increased in all 50 states, for a three-month diffusion index of 100. Additionally, in the past month, the indexes increased in 49 states and remained stable in one state, for a one-month diffusion index of 98."
📈 Near-term GDP growth estimates remain rosy. The Atlanta Fed’s GDPNow model sees real GDP growth climbing at a 2.5% rate in Q1. While the model’s estimate is off its high, it’s nevertheless up considerably from its initial estimate of 0.7% growth as of January 27.
Putting it all together 🤔
Despite recent banking tumult, we continue to get evidence that we could see a bullish “Goldilocks” soft landing scenario where inflation cools to manageable levels without the economy having to sink into recession.
The Federal Reserve recently adopted a less hawkish tone, acknowledging on February 1 that “for the first time that the disinflationary process has started.“ And on March 22, the Fed signaled that the end of interest rate hikes is near.
In any case, inflation still has to come down more before the Fed is comfortable with price levels. So we should expect the central bank to keep monetary policy tight, which means we should be prepared for tighter financial conditions (e.g. higher interest rates, tighter lending standards, and lower stock valuations).
All of this means the market beatings may continue for the time being, and the risk the economy sinks into a recession will be relatively elevated.
However, it’s important to remember that while recession risks are elevated, consumers are coming from a very strong financial position. Unemployed people are getting jobs. Those with jobs are getting raises. And many still have excess savings to tap into. Indeed, strong spending data confirms this financial resilience. So it’s too early to sound the alarm from a consumption perspective.
At this point, any downturn is unlikely to turn into economic calamity given that the financial health of consumers and businesses remains very strong.
And as always, long-term investors should remember that recessions and bear markets are just part of the deal when you enter the stock market with the aim of generating long-term returns. While markets have had a pretty rough couple of years, the long-run outlook for stocks remains positive.
For more on how the macro story is evolving, check out the the previous TKer macro crosscurrents »
For more on why this is an unusually unfavorable environment for the stock market, read: The market beatings will continue until inflation improves 🥊 »
For a closer look at where we are and how we got here, read: The complicated mess of the markets and economy, explained 🧩 »
TKer’s best insights about the stock market 📈
Here’s a roundup of some of TKer’s most talked-about paid and free newsletters about the stock market. All of the headlines are hyperlinked to the archived pieces.
10 truths about the stock market 📈
The stock market can be an intimidating place: It’s real money on the line, there’s an overwhelming amount of information, and people have lost fortunes in it very quickly. But it’s also a place where thoughtful investors have long accumulated a lot of wealth. The primary difference between those two outlooks is related to misconceptions about the stock market that can lead people to make poor investment decisions.
Stomach-churning stock market sell-offs are normal🎢
Investors should always be mentally prepared for some big sell-offs in the stock market. It’s part of the deal when you invest in an asset class that is sensitive to the constant flow of good and bad news. Since 1950, the S&P 500 has seen an average annual max drawdown (i.e., the biggest intra-year sell-off) of 14%.
How stocks performed when the yield curve inverted ⚠️
There’ve been lots of talk about the “yield curve inversion,” with media outlets playing up that this bond market phenomenon may be signaling a recession. Admittedly, yield curve inversions have a pretty good track record of being followed by recessions, and recessions usually come with significant market sell-offs. But experts also caution against concluding that inverted yield curves are bulletproof leading indicators.
How the stock market performed around recessions 📉📈
Every recession in history was different. And the range of stock performance around them varied greatly. There are two things worth noting. First, recessions have always been accompanied by a significant drawdown in stock prices. Second, the stock market bottomed and inflected upward long before recessions ended.
In the stock market, time pays ⏳
Since 1928, the S&P 500 generated a positive total return more than 89% of the time over all five-year periods. Those are pretty good odds. When you extend the timeframe to 20 years, you’ll see that there’s never been a period where the S&P 500 didn’t generate a positive return.
The makeup of the S&P 500 is constantly changing 🔀
Passive investing is a concept usually associated with buying and holding a fund that tracks an index. And no passive investment strategy has attracted as much attention as buying an S&P 500 index fund. However, the S&P 500 — an index of 500 of the largest U.S. companies — is anything but a static set of 500 stocks.
The key driver of stock prices: Earnings💰
For investors, anything you can ever learn about a company matters only if it also tells you something about earnings. That’s because long-term moves in a stock can ultimately be explained by the underlying company’s earnings, expectations for earnings, and uncertainty about those expectations for earnings. Over time, the relationship between stock prices and earnings have a very tight statistical relationship.
When the Fed-sponsored market beatings could end 📈
At some point in the future, we’ll learn a new bull market in stocks has begun. Before we can get there, the Federal Reserve will likely have to take its foot off the neck of financial markets. If history is a guide, then the market should bottom weeks or months before we get that signal from the Fed.
What a strong dollar means for stocks 👑
While a strong dollar may be great news for Americans vacationing abroad and U.S. businesses importing goods from overseas, it’s a headwind for multinational U.S.-based corporations doing business in non-U.S. markets.
Economy ≠ Stock Market 🤷♂️
The stock market sorta reflects the economy. But also, not really. The S&P 500 is more about the manufacture and sale of goods. U.S. GDP is more about providing services.
Stanley Druckenmiller's No. 1 piece of advice for novice investors 🧐
…you don't want to buy them when earnings are great, because what are they doing when their earnings are great? They go out and expand capacity. Three or four years later, there's overcapacity and they're losing money. What about when they're losing money? Well, then they’ve stopped building capacity. So three or four years later, capacity will have shrunk and their profit margins will be way up. So, you always have to sort of imagine the world the way it's going to be in 18 to 24 months as opposed to now. If you buy it now, you're buying into every single fad every single moment. Whereas if you envision the future, you're trying to imagine how that might be reflected differently in security prices.
Peter Lynch made a remarkably prescient market observation in 1994 🎯
Some event will come out of left field, and the market will go down, or the market will go up. Volatility will occur. Markets will continue to have these ups and downs. … Basic corporate profits have grown about 8% a year historically. So, corporate profits double about every nine years. The stock market ought to double about every nine years… The next 500 points, the next 600 points — I don’t know which way they’ll go… They’ll double again in eight or nine years after that. Because profits go up 8% a year, and stocks will follow. That's all there is to it.
Warren Buffett's 'fourth law of motion' 📉
Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.
'Past performance is no guarantee of future results,' charted 📊
S&P Dow Jones Indices found that funds beat their benchmark in a given year are rarely able to continue outperforming in subsequent years. According to their research, 29% of 791 large-cap equity funds that beat the S&P 500 in 2019. Of those funds, 75% beat the benchmark again in 2020. But only 9.1%, or 21 funds, were able to extend that outperformance streak into 2021.
One stat shows how hard it is to pick market-beating stocks 🎲
Picking stocks in an attempt to beat market averages is an incredibly challenging and sometimes money-losing effort. In fact, most professional stock pickers aren’t able to do this on a consistent basis. One of the reasons for this is that most stocks don’t deliver above-average returns. According to S&P Dow Jones Indices, only 22% of the stocks in the S&P 500 outperformed the index itself from 2000 to 2020. Over that period, the S&P 500 gained 322%, while the median stock rose by just 63%.
Here’s more detail from the Philly Fed: “The coincident indexes combine four state-level indicators to summarize current economic conditions in a single statistic. The four state-level variables in each coincident index are nonfarm payroll employment, average hours worked in manufacturing by production workers, the unemployment rate, and wage and salary disbursements deflated by the consumer price index (U.S. city average). The trend for each state’s index is set to the trend of its gross domestic product (GDP), so long-term growth in the state’s index matches long-term growth in its GDP.“
Great article, Sam, thank you for pointing out the difficulty in unraveling the counterfactual scenarios around Fed monetary policy! For so many, it’s easy to look back and be critical! It’s good to review the fact that were present when the decision was made… I would be pretty miserable if I always criticized my investment decisions without the context of the data that was available at the time!
When thinking about the Fed counterfactual, I think about what was happening in the US-
The folks who argue that the Fed was slow generally assert that the Fed should've been removing emergency measures at least 18-20 months ago -- sometime in the summer of 2021. But consider what was happening at that time:
• The Delta variant was rising (provoking a new wave of deaths and fear) and school was restarting.
• The vaccine had been out for 3-6 months -- presumably the major solution to this whole big mess -- and inoculation rates were low
• The unemployment rate had returned to it's pre-pandemic low, but MANY workers were not returning to the workforce yet. One predominant theory being: they were still spooked by a Pandemic & more concerned for their own personal health safety.
So there was a great deal of uncertainty about what new strains of COVID (after Delta, Omicron) might mean for the economy. It's understandable that they were cautious & erring in favor of supporting employment.
It's just that that choice led to the tightest labor market in memory. The criticism isn't unfair, IMO. It just usually doesn't offer a fair recounting of the major factors involved with decisions at the time.