The other side of the Fed's inflation 'mistake' 🧐
The other side of the Fed's inflation 'mistake' 🧐
Plus a charted review of the macro crosscurrents 🔀
📉 Stocks fell last week, with the S&P 500 declining 4.2% to end at 5,408.42. The index is now up 13.4% year to date and up 51.2% from its October 12, 2022 closing low of 3,577.03. For more on recent stock market moves, read: September is already living up to its bad reputation 🍂
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In the context of inflation, was the Federal Reserve late to tighten monetary policy and hike interest rates? Most would agree the answer is yes.
But the Fed doesn’t have just one mandate of promoting price stability. It has a dual mandate of promoting both price stability and maximum employment.
Taking employment into consideration, it’s less obvious to me that the Fed was late to tighten monetary policy.
I can’t pinpoint exactly when the calls to tighten began when inflation was heating up three years ago. But we can all agree that these calls grew loudest ahead of the Fed’s first rate hike in March 2022.
As you can see in the chart below, the core PCE price index (blue line) — the Fed’s preferred measure of inflation — was at a high of 5.5% in March 2022. Clearly, inflation was a problem.
That same month, the unemployment rate (red line) was 3.6%, the lowest level since before the pandemic.
The unemployment rate effectively bottomed that month, mostly trending sideways as inflation rates cooled.
What if the Fed acted earlier? 🤔
I generally don’t like considering counterfactual scenarios because the world is complex, and no one can say with certainty what would’ve actually happened in the past if certain things had gone differently. But since we continue to hear folks casually say that we would’ve been better off if the Fed acted earlier, I’ll indulge in the thought exercise.
What if the Fed hiked rates at its January 2022 meeting? Maybe our inflation mess would’ve ended a little sooner. But the unemployment rate was higher at 4%. Would we have been okay with the unemployment rate trending at 4%? Maybe.
What if we went back a little further, and the Fed hiked rates at its October/November 2021 meeting? The core PCE price index was increasing at about a 4.5% rate. Price-sensitive consumers would’ve been much happier to see inflation top out there. But the unemployment rate was higher at about 4.5%. Does the cost of keeping unemployment almost a full percentage point higher justify the benefit of keeping prices a bit cooler?
What if the Fed moved even sooner when the unemployment rate was even higher?
The big picture 🖼️
Here’s my point: While it’s fair to argue the Fed hiked rates too late in the context of inflation, I don’t think it’s fair to argue they made a mistake — especially when you consider the goals of monetary policy in their entirety, which include promoting maximum employment.
While high inflation is a headache for consumers, at least some of it was the result of newly employed people finally being able to afford to purchase goods and services.
Like I said before, the world is complex. So who knows? Maybe there’s a scenario where the Fed tightened monetary policy sooner and the unemployment rate continued to fall anyway as inflation cooled.
But the likely outcome of tighter monetary policy earlier in this economic cycle would have been unemployment bottoming at a higher level than what we’ve experienced.
I’m not suggesting the Fed was right or wrong to adjust monetary policy when it did. I’m just saying that you cannot talk about how monetary policy actions affect inflation without addressing how they affect employment.
How about instead of proclaiming that the Fed was late in the context of inflation — which is not a controversial view — we instead tackle the philosophical question of how we balance the tradeoff between price stability and employment. How many people is it okay to leave unemployed if it means improving price stability?
The state of play 🏛️
Over the past two and a half years, inflation rates have cooled significantly. And while the unemployment rate remains low by historical standards, it has been trending a bit higher.
Last month when the unemployment rate was 4.3%, Fed Chair Jerome Powell said: “We do not seek or welcome further cooling in labor market conditions.“
“The time has come for policy to adjust,” he added. It was one of the more explicit signals that rate cuts would begin soon, a development most market participants welcome.
Of course, there are also voices brushing off the rise in unemployment as they argue that the Fed should wait longer until inflation is defeated more definitively.
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Related from TKer:
Reviewing the macro crosscurrents 🔀
There were a few notable data points and macroeconomic developments from last week to consider:
👍 The labor market continues to add jobs. According to the BLS’s Employment Situation report released Friday, U.S. employers added 142,000 jobs in August. It was the 44th straight month of gains, reaffirming an economy with growing demand for labor.
Total payroll employment is at a record 158.8 million jobs, up 6.4 million from the prepandemic high.
The unemployment rate — that is, the number of workers who identify as unemployed as a percentage of the civilian labor force — declined to 4.2% during the month. While it continues to hover near 50-year lows, the metric is near its highest level since October 2021.
While the major metrics continue to reflect job growth and low unemployment, the labor market isn’t as hot as it used to be.
For more on the labor market, read: The labor market is cooling 💼 and There are 'rules' and then there are 'statistical regularities' 🧮
💸 Wage growth ticks up. Average hourly earnings rose by 0.4% month-over-month in August, up from the 0.2% pace in July. On a year-over-year basis, this metric is up 3.8%, near the lowest rate since June 2021.
For more on why policymakers are watching wage growth, read: Revisiting the key chart to watch amid the Fed's war on inflation 📈 and Fed Chair Powell: 'The time has come' ⏰
💼 Job openings fall. According to the BLS’s Job Openings and Labor Turnover Survey, employers had 7.76 million job openings in July, down from 7.91 million in June. While this remains slightly above prepandemic levels, it’s down significantly from the March 2022 high of 12.18 million.
During the period, there were 7.16 million unemployed people — meaning there were 1.07 job openings per unemployed person. Once a sign of excess demand for labor, this telling metric is now below prepandemic levels.
For more on job openings, read: A once massive economic tailwind has faded 💨 and Revisiting the key chart to watch amid the Fed's war on inflation 📈
👍 Layoffs remain depressed. Employers laid off 1.76 million people in July. While challenging for all those affected, this figure represents just 1.1% of total employment. This metric continues to trend near pre-pandemic low levels.
For more on layoffs, read: Every macro layoffs discussion should start with this key metric 📊
Hiring activity continues to be much higher than layoff activity. During the month, employers hired 5.52 million people, up from 5.25 million in June.
For more on why this metric matters, read: Watch hiring activity 👀
🤔 People are quitting less. In July, 3.28 million workers quit their jobs. This represents 2.1% of the workforce. While up from the prior month, it remains below the prepandemic trend.
A low quits rate could mean a number of things: more people are satisfied with their job; workers have fewer outside job opportunities; wage growth is cooling; productivity will improve as fewer people are entering new unfamiliar roles.
For more, read: Promising signs for productivity ⚙️
💪 Labor productivity inches up. From the BLS: “Nonfarm business sector labor productivity increased 2.5% in the second quarter of 2024… as output increased 3.5 percent and hours worked increased 1.0%. … From the same quarter a year ago, nonfarm business sector labor productivity increased 2.7%.”
💼 Unemployment claims ticked lower. Initial claims for unemployment benefits declined to 227,000 during the week ending August 31, down from 232,000 the week prior. While this metric continues to be at levels historically associated with economic growth, recent prints have been trending higher.
For more on the labor market, read: The labor market is cooling 💼
💳 Card spending data is stable. From Bank of America: “Total card spending per household was up 2.8% y/y in week ending Aug 31, according to BAC aggregated credit & debit card data. This increase was likely driven by the change in the timing of Labor Day compared to last year (09/02/24 versus 09/04/24). Within sectors, furniture saw the biggest increase since last week, while entertainment showed the largest decline.”
For more on personal consumption, read: The state of the American consumer in a single quote 🔊
⛽️ Gas prices fall. From AAA: “After idling over the Labor Day weekend, the national average for a gallon of gas resumed its pace of daily declines by falling six cents since last week to $3.30. Key contributors are low gas demand and the plunging cost of oil, which is struggling to stay above $70 a barrel.”
For more on energy prices, read: Higher oil prices meant something different in the past 🛢️
🏠 Mortgage rates hold steady. According to Freddie Mac, the average 30-year fixed-rate mortgage stood at 6.35% this week. From Freddie Mac: “Even though rates have come down over the summer, home sales have been lackluster. On the refinance side however, homeowners who bought in recent years are taking advantage of declining mortgage rates in order to lower their monthly payments.”
There are 146 million housing units in the U.S., of which 86 million are owner-occupied and 39% of which are mortgage-free. Of those carrying mortgage debt, almost all have fixed-rate mortgages, and most of those mortgages have rates that were locked in before rates surged from 2021 lows. All of this is to say: Most homeowners are not particularly sensitive to movements in home prices or mortgage rates.
For more on mortgages and home prices, read: Why home prices and rents are creating all sorts of confusion about inflation 😖
🔨 Construction spending ticks lower. Construction spending declined 0.3% to an annual rate of $2.16 trillion in July.
👍 Services surveys look up. From S&P Global’s August U.S. Services PMI: “An improvement in the headline services PMI to its highest for nearly two-and-a-half years provides further encouraging evidence that the US economy is enjoying robust economic growth in the third quarter, adding to signs of a ‘soft landing’. The faster service sector expansion means the PMI surveys are signalling GDP growth of 2-2.5% in the third quarter. At the same time, the August survey data signaled a further cooling of selling price inflation, notably in the service sector, which has now eased close to the average seen prior to the pandemic and a level consistent with the Fed’s 2% inflation target.”
The ISM’s August Services PMI also signaled growth in the sector.
👎 Manufacturing surveys don’t look great. From S&P Global’s August U.S. Manufacturing PMI: “A further downward lurch in the PMI points to the manufacturing sector acting as an increased drag on the economy midway through the third quarter. Forward-looking indicators suggest this drag could intensify in the coming months. Slower than expected sales are causing warehouses to fill with unsold stock, and a dearth of new orders has prompted factories to cut production for the first time since January. Producers are also reducing payroll numbers for the first time this year and buying fewer inputs amid concerns about excess capacity.”
Similarly, the ISM’s August Manufacturing PMI signaled contraction in the industry.
Keep in mind that during times of perceived stress, soft survey data tends to be more exaggerated than hard data.
For more on this, read: What businesses do > what businesses say 🙊
📈 Factory orders jump. According to the Census Bureau, new orders for manufactured goods rose 5% to $592.1 billion in July.
📈 Key recession indicators point to growth. Here’s a great chart from economist Justin Wolfers tracking the trajectory of key measures of economic activity.
For more on how recessions are defined, read: You call this a recession? 🤨
📈 Near-term GDP growth estimates remain positive. The Atlanta Fed’s GDPNow model sees real GDP growth climbing at a 2.1% rate in Q3.
For more on economic growth, read: Economic growth: Slowdown, recession, or something else? 🇺🇸
Putting it all together 🤔
We continue to get evidence that we are experiencing a bullish “Goldilocks” soft landing scenario where inflation cools to manageable levels without the economy having to sink into recession.
This comes as the Federal Reserve continues to employ very tight monetary policy in its ongoing effort to get inflation under control. Though, with inflation rates having come down significantly from their 2022 highs, the Fed has taken a less hawkish tone in recent months, even signaling that rate cuts could come later this year.
It would take a number of rate cuts before we’d characterize monetary policy as being loose, which means we should be prepared for relatively tight financial conditions (e.g., higher interest rates, tighter lending standards, and lower stock valuations) to linger. All this means monetary policy will be relatively unfriendly to markets for the time being, and the risk the economy slips into a recession will be relatively elevated.
At the same time, we also know that stocks are discounting mechanisms — meaning that prices will have bottomed before the Fed signals a major dovish turn in monetary policy.
Also, it’s important to remember that while recession risks may be elevated, consumers are coming from a very strong financial position. Unemployed people are getting jobs, and those with jobs are getting raises.
Similarly, business finances are healthy as many corporations locked in low interest rates on their debt in recent years. Even as the threat of higher debt servicing costs looms, elevated profit margins give corporations room to absorb higher costs.
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 recently had some bumpy 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 »
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.
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.
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%.
High and rising interest rates don't spell doom for stocks👍
Generally speaking, rising interest rates are not welcome news for the economy and the stock market. They represent higher financing costs for businesses and consumers. All other things being equal, rising rates represent a hindrance to growth. However, the world is complicated, and this narrative comes with a lot of nuance. One big counterintuitive piece to this narrative is that historically, stocks have actually performed well during periods of rising interest rates.
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.
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.
Most pros can’t beat the market 🥊
According to S&P Dow Jones Indices (SPDJI), 59.7% of U.S. large-cap equity fund managers underperformed the S&P 500 in 2023. As you stretch the time horizon, the numbers get even more dismal. Over a three-year period, 79.8% underperformed. Over a 10-year period, 87.4% underperformed. And over a 20-year period, 93% underperformed. This 2023 performance follows 13 consecutive years in which the majority of fund managers in this category have lagged the index.
Proof that 'past performance is no guarantee of future results' 📊
S&P Dow Jones Indices found that funds beat their benchmark in a given year are rarely able to continue outperforming in subsequent years. For example, 334 large-cap equity funds were in the top half of performance in 2021. Of those funds, 58.7% came in the top half again in 2022. But just 6.9% were able to extend that streak through 2023. If you set the bar even higher and consider those in the top quartile of performance, just 20.1% of 164 large-cap funds remained in the top quartile in 2022. No large-cap funds were able to stay in the top quartile for the three consecutive years ending in 2023.
The odds are stacked against stock pickers 🎲
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 24% of the stocks in the S&P 500 outperformed the average stock’s return from 2000 to 2022. Over this period, the average return on an S&P 500 stock was 390%, while the median stock rose by just 93%.
Very helpful, thank you!