September 21st the Federal Reserve announced that they would be increasing their Federal Funds Interest Rate by 0.75% and provided guidance that they expect to increase the rate by another roughly 1.5% by the end of the year. The interest rate hike was expected, but the guidance was more extreme than expected. Here are highlights separated by what I consider good and bad moving forward.
Bad
- I will get right to the point; this Federal Reserve announcement does not make sense to me. The Fed Funds Rate at the beginning of the year was basically 0% and now is roughly 3%. There are very few times in history that we have increased interest rates this aggressively. This has caused the average 30-year mortgage rate to move from 3% at the start the year to over 6% now. The U.S. dollar has strengthened to 20-year highs which causes imports to be cheaper, but our exports to be more expensive. This all feels more extreme than necessary.
- When the Federal Reserve raises or lowers their interest rate, it is estimated that it takes 4-6 months to influence our economy. Since the first interest rate increase was in March of 2022, that would mean that we are only now beginning to feel the effects from the first interest rate increases. Why not pause to take inventory to see if more is needed. I don’t see the benefit of then lowering interest rates if the Federal Reserve determines that they have gone too far.
- I’m borrowing this from Josh Brown (CNBC Commentator) who tweeted the following: “This recession is necessary to prevent the next recession. -Fed policy, literally” I have been firmly in the camp that I don’t think we will have a recession as unemployment and other measures of the health of the economy have stayed relatively strong. One of my caveats for concern were that we did not experience a policy error from the government, foreign government, or a global Central Bank. What do I mean by policy error? This would be raising taxes aggressively, cutting government spending aggressively, China expanding their Zero COVID policy, more spillover from the Russian Invasion and/or the Federal Reserve completely performing a U-Turn to go from a significant supporter of our economy to create a mandate to slow our economy. Remember, the Federal Reserve kept telling us inflation would be short lived, so they are now responding to their own mistake. At what point do we ask if they are more focused on their own credibility versus there actual job function. Does this mean that everything is doom and gloom? Let’s look at the Good.
Good
- The Federal Reserve keeps referencing old inflation data. The input costs that lead to future inflation have been declining. This sets up an interesting scenario were one of the next inflation reports shows a significant decrease in inflation which could ignite a significant rally. Wall Street could read this as the Federal Reserve can stop their interest rate hikes. Also, picture this scenario, Social Security recipients experience a 8-9% increase in their income at the same time inflation comes down. This could lead them to have excess income against their expenses. Now expand this scenario to workers that receive a large increase in their income to offset past inflation, but inflation instead comes down. Same thing, they would have more to spend.
- If you are thinking that can’t happen because the Federal Reserve has prognosticated differently, please don’t. The Federal Reserve has been terrible at predicting the future. I was at a speech by a Fed Governor, and he made jokes about how poor the Federal Reserve’s crystal ball has been.
- The unemployment rate is still at basically all-time lows. We still have too many job openings for the people willing to take them. One of the reasons why larger drops happen in the stock market are laid off workers need to use their retirement savings to live until they are hired again. If the unemployment rate stays low, then workers are still adding to their retirement savings.
- Finally, the yield curve that I keep referencing as a sign of a future recession (3 Month Treasury Bills vs. 10 Year Treasury Bonds) is still not inverted. As I have written previously, if this inverts for one quarter, the chances of a recession are usually very high. The fact that it has not so far is an encouraging sign.
Summary
So where does this leave us? I maintain my belief that we are in the process of weathering the inflation storm if you will, but the Federal Reserve is making me less confident then I was. We will keep monitoring and the next couple inflation reports are going to be very interesting.