It’s too early to start celebrating. This is the sovereign message from the Federal Reserve – even if, given half a chance, the markets will not take it into account.
At a news conference Wednesday and in written statements after its latest policy meeting, the Fed did what it could to contain Wall Street’s enthusiasm.
“It’s far too early to declare victory and there are certainly risks” that the economy still faces, said Jerome H. Powell, chairman of the Fed. But stocks still soared, with the S&P 500 poised to hit a new record high.
The Fed said it was too early to count on a “soft landing” for the economy – a reduction in inflation without a recession – although that is increasingly the consensus on Wall Street. An early cut in the federal funds rate, the short-term benchmark rate that the Fed directly controls, is also not a sure thing, although Mr. Powell said the Fed has begun discussing rate cuts and that the markets were, more and more, relying on them.
Markets have been rising since July – and have been positively buoyant since late October – on the assumption that real good times are on the horizon. This might turn out to be a correct assumption – one that could be helpful to President Biden and the rest of the Democratic Party in the 2024 elections.
But if you were looking for certainty about a cheery 2024, the Fed didn’t provide it at this week’s meeting. Instead, it has gone out of its way to say it is positioning itself for maximum flexibility. Cautious investors may want to do the same.
Reasons to be optimistic
On Wednesday, the Fed announced it would keep the federal funds rate where it currently stands, at around 5.3 percent. This is about 5 percentage points higher than at the start of 2022.
Inflation, a glaring economic problem at the start of the year, has fallen sharply thanks, in part, to these sharp increases in interest rates. The consumer price index rose 3.1 percent in the year to November. This figure remains significantly above the Fed’s 2% target, but well below the inflation rate. peak of 9.1 percent in June 2022. And because inflation has fallen, a virtuous circle has developed, from the Fed’s perspective. Since the federal funds rate is significantly higher than the inflation rate, the real interest rate has been rising since July, without the Fed needing to act directly.
But Mr Powell says rates need to be “restrictive enough” to ensure inflation doesn’t return. And, he warned, “we will need additional evidence to be sure that inflation is moving closer to our target.”
The wonderful thing about the Fed’s tightening of interest rates so far is that it hasn’t triggered a big increase in unemployment. The latest figures show the unemployment rate was just 3.7 percent in November. on a historical basis, this is an extraordinarily low rate, coupled with a robust, not weak, economy. Economic growth accelerated in the three months to September (the third quarter), with gross domestic product growing at an annual rate of 4.9 percent. This doesn’t look at all like the recession widely anticipated a year ago.
On the contrary, with indicators of robust economic growth like these, it is no wonder that long-term interest rates in the bond market have fallen in anticipation of the Fed’s rate cuts. THE federal funds futures market On Wednesday, he predicted reductions in federal funds starting in March. By the end of 2024, the futures market expects the federal funds rate to fall below 4%.
But on Wednesday, the Fed planned a slower, more modest cut, bringing the rate down to around 4.6 percent.
Too early to relax
Several other indicators are less positive than the markets have been. The pattern of Treasury rates, known as the yield curve, has been predicting a recession since November 8, 2022. Short-term rates – particularly for three-month Treasury bonds – are higher than longer-term ones duration – particularly for 10-year Treasury bonds. . In financial jargon, this is an “inverted yield curve” which often predicts a recession.
Another proven economic indicator has also flashed recession warnings. The main economic indicatorsan index formulated by the Conference Board, an independent economic think tank, “signals a near-term recession,” Justyna Zabinska-La Monica, a senior executive at the Conference Board, said in a statement.
The consensus of economists measured in independent surveys from Bloomberg and Blue Chip Economic Indicators no longer predicts a recession over the next 12 months – contrary to the prevailing view earlier this year. But more than 30 percent of economists in the Bloomberg survey and 47 percent of those at Blue Chip Economic Indicators disagree and believe that a recession within the next year will indeed occur.
As economic growth, as measured by gross domestic product, emerges, the first data To show that it is slowing significantly, as high interest rates gradually cause damage to consumers, small businesses, the housing market and more. Over the past two years, fiscal stimulus from residual pandemic aid and deficit spending have thwarted restraint efforts. of monetary policy. Consumers are spending aggressively at stores and restaurants, helping to avoid an economic downturn.
Despite this, a parallel measure of economic growth – gross domestic income – has operated at a much lower rate than GDP over the past year. Gross domestic income has sometimes proven to be a more reliable short-term measure of downturns. Ultimately, the two measures will be reconciled, but we will not know in which direction for months.
The stock and bond markets are more than impatient to see the tightening of the monetary belt stop.
The US stock market has already advanced this year and is almost back to its January 2022 peak. And after the worst year in modern times for bonds in 2022, market returns for the year are now positive for investment grade bonds. quality. bond funds – which track the benchmark Bloomberg US Aggregate Bond Index – which are part of core investment portfolios.
But based on corporate profits and revenues, U.S. stock prices are tight and bond market yields reflect a consensus that a soft landing for the economy is a near certainty.
These market movements can be fully justified. But they imply a near-perfect Goldilocks economy: Inflation will continue to fall, allowing the Fed to cut interest rates early enough to avoid economic calamity.
But excessive market exuberance alone could upset this outcome. Mr. Powell has frequently spoken about the tightening and loosening of financial conditions in the economy, which are determined in part by the level and direction of stock and bond markets. Too much recovery, occurring too soon, could prompt the Fed to delay lowering rates.
All of this will impact the 2024 elections. Prosperity tends to favor incumbents. Recessions tend to favor challengers. It is too early to make a sure bet.
Without some knowledge, the best most investors can do is prepare for all eventualities. This means staying diversified, with a broad portfolio of stocks and bonds. Hang in there and hope for the best.