The Fed's Battle Against Inflation


Evidence continues to grow that the Fed was caught wrong-footed by how rapidly the economy has recovered.

Unemployment has fallen more quickly than expected and wages have moved higher. The healing of the labor market and emergence of higher inflation has resulted in a shift in the Fed’s focus towards tackling inflation, a dramatic change from recent years when it was more worried about inflation persistently running below its targeted 2% level. In less than a year, the Fed has transitioned from forecasting no rate increases before 2024 to now expecting as much as a half-point rate hike in March 2022. To be fair, this wasn’t easy terrain to navigate, as the Fed was reacting to a multitude of highly variable factors such as how quickly the virus receded and how quickly supply chains healed.

The January CPI showed inflation of 7.5%, a 40-year high that was ahead of already elevated expectations. Core prices advanced 6.0%. Supply and demand imbalances related to the pandemic continue to contribute to higher levels of inflation; however, price pressures have broadened, and inflation tends to be sticky. A stronger economy is pushing up rents and wages, which appears likely to keep inflation elevated even after supply-chain disruptions ease. Despite downward pressure on inflation as supply chains normalize and base effects take hold, it seems rather presumptuous to believe inflation will cooperate by gently trending lower to the targeted 2%.Implied longer-term inflation expectations reflect confidence the Fed will be able to effectively manage inflation.

While inflation is the primary current focus, the employment market paints a sunnier picture. January jobs data vastly exceeded modest expectations. Employers added 467,000 jobs, while the unemployment rate increased to 4.0% from 3.9% as more people joined the workforce. Employers also added 709,000 more jobs in November and December than initially expected. The U.S. still has about 2.5 million fewer people employed than in January 2020, even as the economy has exceeded its pre-pandemic size. It is hard to argue we are not currently near full employment and the tight job market is feeding wage inflation.

In its efforts to combat inflation by slowing the economy, the Fed risks causing a recession. Historically, attempts to bring down inflation have done just that. Despite a clear shift in its stance, the Fed is exercising some restraint in not moving too quickly so as not to disrupt markets. As a result, it is currently in the awkward position of continuing its bond purchases while inflation is running multiples of its targeted level. After initiating a plan to reduce its monthly bond buying last November, the final round of bond purchases will conclude in March, adding to a balance sheet already holding more than $9 trillion, more than double two years ago.

The ongoing bond purchases reflect a particularly odd dynamic given inflation concerns have risen to a level where there is at least some consideration of not only letting bonds mature without reinvesting proceeds, as the Fed did between 2017 and 2019, but also of outright sales. The Fed prefers to implement policy via interest rate hikes, as there is greater uncertainty as to how the economy and investors will respond to changes in the balance sheet. Ideally, it would prefer to mirror the mechanics of the balance sheet runoff in 2017-2019, allowing bonds to mature without reinvesting the proceeds, while simultaneously raising rates.

Prior to any balance sheet reduction, there will be rate increases. Following the January CPI report, the question shifted from whether the Fed will raise short-term rates at its March meeting, to by how much? It is a near certainty there will be at least a quarter-point increase and the CME FedWatch tool indicates about a 50% probability of a half-point increase at that meeting. For the year, the consensus expectation is for the Fed to raise rates seven times assuming quarter point increases, bringing the target rate to 1.75%-2.00%. This is consistent with recent communications by Fed officials and is referred to a "neutral" rate, of which estimates vary but generally fall in a range of 2%-3% assuming inflation returns to more normalized levels.

In this context, a focus on fundamentals becomes even more important. In contrast to the speculative frenzy that took hold of markets in early 2021, the current backdrop is one that should favor companies with solid and improving fundamentals. The three featured stocks in the March 2022 issue of the Investor Advisory Service stock newsletter represent our team's best opportunities in the current climate.

Reprinted from the March 2022 issue of the Investor Advisory Service stock newsletter, rated #1 for performance in 2021 by Hulbert Ratings.

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