Clarity about the future of inflation and the stock and bond markets would be wonderful right now, but that’s just what we don’t have.
What we do have are enormous quantities of inconclusive data. There is something for everyone, and for every possible interpretation.
The Federal Reserve is intent on whipping inflation now — to borrow an infamous phrase from the Ford administration, which failed spectacularly to “WIN” in the 1970s. But despite a series of steep interest rate increases by the Fed, and its stated intention to raise rates further this year, inflation remains intolerably high.
“We’re stuck in the messy middle,” Josh Hirt, senior economist at Vanguard, said in a note this month.
It’s a muddle right now, and the lurching stock and fixed-income markets reflect investors’ uncertainty.
In testimony before Congress on Tuesday and Wednesday, Jerome H. Powell, the Fed chair, made it clear that the central bank not only intends to keep raising interest rates, but will increase them even more than “previously anticipated” if it deems that necessary to squelch inflation.
It’s too soon to say how effective the measures taken by the Fed have been. The economy has been generating a lot of jobs and unemployment is quite low, but corporate earnings are beginning to fall. At some point, the economy is going to slow down — Vanguard thinks that may not happen until the end of the year. We may be heading into a recession. Or we may not be. The verdict isn’t in yet.
Really long-term investors can ride out the turmoil, and those who prize safety above all else have reasonably good options now, too: There are plenty of attractive, high-interest places to park your cash.
But what transpires in the next few months will still be critical for consumers and investors, and may even determine the outcome of the next presidential election. Considering what’s at stake, it is worth wading a little more deeply into this morass.
The Fed and Inflation
The Fed finds itself in a difficult spot. It has declared that it intends to bring inflation down to its longtime 2 percent target, but prices keep rising much faster than that.
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The decline of the stock and bond markets this year has been painful, and it remains difficult to predict what is in store for the future.
That 2 percent target is an arbitrary number, without much science to it. Whether 2 percent inflation is better than, say, 1.5 or 2.5 or 3 percent inflation — and how the inflation rate should be measured — are all open for debate. Let’s save those issues for another day.
For now, the Fed has drawn a red line at 2 percent, and its credibility is at stake. The Consumer Price Index in January rose at more than three times that target rate. The Personal Consumption Expenditures price index, which the Fed favors — and which, not coincidentally, generally produces lower readings than the C.P.I. — rose at a 5.4 percent annual rate in January, which was more than in the previous month. No matter how you slice it, inflation is ugly.
So the Fed has few immediate options. It will keep raising the federal funds rate, the short-term interest rate it controls, in an effort to slow the economy and squelch inflation. The only questions are how high it will go and how rapidly it will get there. Traders in the bond market, who set longer-term rates through bidding and purchases, have had trouble coming up with consistent answers.
The central bank has already raised the short-term federal funds rate substantially and quickly, to a range of 4.5 to 4.75 percent, up from near zero just a year ago. But the federal funds rate is a blunt instrument, and the economic effects of these rate increases operate with a significant lag,
The Fed could easily plunge the economy into a major recession. In a misguided bet that the Fed would beat inflation quickly or that a recession would arrive so definitively that the Fed could reverse course, bond traders began moving longer-term rates lower in October. That optimism also set off a stock market rally.
But lately, with inflation and the economy failing to respond as traders had expected, the outlook has turned gloomier. Treasury yields reached or exceeded 5 percent for so-called risk-free securities in the range of three months to two years. That’s an attractive proposition in comparison with the stock market, and it’s no accident that stocks have fallen.
Bonds and Stocks
Even 10-year Treasury yields have ascended to the 4 percent range. Compared with stocks, Treasuries in a murky market are, for the moment, exceptionally attractive.
Falling earnings haven’t helped the stock market, either. For the last three months of 2022, the earnings of companies in the S&P 500 declined 3.2 percent from a year earlier, according to the latest I/B/E/S data from Refinitiv. And if you exclude the windfall from the energy sector, where prices were bolstered by Russia’s war in Ukraine, earnings fell 7.4 percent, the data showed.
Corporate prospects for 2023 have begun to dim a bit, too, executives and Wall Street analysts are concluding. On Feb. 21, both Home Depot and Walmart warned that consumer spending had come under strain. The S&P 500 fell 2 percent that day, the worst performance for the short year to that date, in what Howard Silverblatt, a senior analyst for S&P Dow Jones Indices, called a “turnaround point” for the stock market.
It’s early yet in 2023, but so far, stock investors are maintaining a relentless focus on the Fed, whose policymakers next meet March 21 and 22 and are all but certain to raise short-term interest rates further. The only questions are by how much, and how high rates will end up before the Fed concludes that it has accomplished its objective.
But with Mr. Powell aspiring to achieve the performance of his illustrious predecessor Paul A. Volcker, who vanquished inflation in the 1980s and set off two recessions to do it, it’s a fair bet that the Fed won’t back off its rate tightening policy soon.
Bring down inflation and you are likely to be remembered as a hero. Bungle the job and you may well be memorialized as officials in President Gerald R. Ford’s administration have been, for their hapless effort to “whip inflation now.”
In a widely derided public relations stunt in 1974, when inflation was running above 12 percent, the Ford White House distributed buttons with the WIN acronym, but that administration never beat inflation.
It wasn’t until the next president, Jimmy Carter, appointed Mr. Volcker that the Fed even began to get control of inflation — and Mr. Volcker didn’t finish the job until the Reagan administration was well underway.
The 2024 Election
The outcome of the next presidential election could well depend on whether the Fed gets the job done this time — and whether it causes a severe recession in the process.
Ray Fair, a Yale economics professor who has been predicting presidential and congressional elections for decades, points out in a succinct note on his website that the political effects of the Fed’s efforts will be large. In his work, Professor Fair relies only on economic variables — and not the customary staples of political analysis — to forecast elections. His record is excellent.
He outlines two paths for the economy. Because President Biden is an incumbent, and is likely to run for re-election, good economic results would be expected to help his cause.
“In the positive case for the Democrats, if inflation is 3 percent in 2023 and 2 percent in 2024,” Professor Fair wrote, and if the economy grows at 4 percent rate in 2024 before the election, his economic model says the Democratic candidate is highly likely to win the presidency.
On the other hand, he said, “in the negative case for the Democrats, if inflation is 5 percent in 2023 and 4 percent in 2024” and if the economy shrinks 2 percent in 2024 — in a recession — a Republican is highly likely to be the next president. He added, “Somewhere in between regarding the economy will mean a close election.”
These statements assume that only the two main political parties mount credible campaigns. A well run third-party candidacy would complicate matters considerably.
I’m not making any bets, either on politics or on the economy. It’s all too complex and confused now.
As always, for investments of at least a decade and, preferably, longer, low-cost index funds that mirror the entire markets are a good choice.
Bonds are a safe and well-paying option right now. So is cash, held in money market funds or high-yield bank savings accounts.
We may well be at a turning point, but taking us where, exactly? Unless you somehow know, it may be wise to play it safe for a while.
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