The Markets Are Counting on the Fed to Solve a Tricky Puzzle

It’s entirely possible that the Federal Reserve has mastered a vexing economic puzzle — taming runaway inflation without causing undue financial hardship for millions of people.

But I don’t think we can count on it, despite the good news that has been arriving regularly lately.

The most important reason for optimism comes from a nonevent: The long-predicted recession of 2023 simply hasn’t happened. Not yet, anyway. But I think we’re still in a danger zone, even if it isn’t obvious.

The Fed has already raised interest rates more in the last year or so than it had in any comparable stretch since the early 1980s, another period when inflation was soaring. The Fed’s inflation-fighting strategy is clear, and it comes straight out of the textbooks.

When rates rise swiftly and consistently, that tends to have the effect of slowing economic growth and, eventually, reversing it. Such a slowdown, accompanied by painful job losses, is the standard prescription for wringing excessive inflation out of the economy. Higher rates are supposed to be bitter medicine.

That’s not what we’ve been experiencing, though. Instead, inflation has been trending down while the unemployment rate has remained remarkably low — an unexpected and appealing pairing of seeming opposites, like hot fudge drizzled over ice cream. Let’s have more of that! No wonder the markets have been rallying.

Yet don’t forget that the Fed meets again on Tuesday and Wednesday, and the futures markets are overwhelmingly predicting another 0.25-point increase in the federal funds rate, which has already risen from near zero in March last year to a range of 5 to 5.25 percent. The markets have been acting as though that hefty series of rate increases is inconsequential, as far as gross domestic product, corporate earnings and the stock and bond markets go.

The Good News First

Undeniably, there has been plenty of good news, and many market strategists have been greeting it joyfully.

Inflation has hurt many households, but it is now declining. The latest government report showed the Consumer Price Index dropping to a 3 percent annual rate in June, down from 4 percent in May. That’s still well above the Fed’s 2 percent target, but it’s coming within shooting range of it.

The remarkable thing is that, at the same time, the labor market remains strong. The unemployment rate in June was 3.6 percent, seasonally adjusted — an extremely low number on a historical basis and still within the range of 3.4 percent to 3.7 percent, where it has been anchored since March 2022.

The soaring inflation of the last couple of years — C.P.I. inflation peaked at 9.1 percent in June 2022 — was partly caused by the pandemic and the emergency rescue packages, both fiscal and monetary, aimed at alleviating the pandemic’s economic effects. For a while, the Fed said high inflation was “transitory” and would ebb on its own. The threat of deflation had been the central bank’s main worry for years, and it took a while to adjust to the new reality.

But by the end of 2021, the Fed had deemed inflation unacceptably high, and it began signaling that it would not continue its expansive monetary policy indefinitely. That included near-zero interest rates and the purchase of $120 billion a month of Treasury bonds and mortgage-backed securities in the unorthodox stimulus program known as quantitative easing. In January 2022, the Fed made its intention to tighten absolutely clear, and the markets plummeted.

Causes of Inflation

Even now, after inflation has begun to cool, it’s difficult to disentangle the causes of the great inflation of 2022 — the extent to which supply-chain snafus, enormous amounts of deficit spending and monetary stimulus, and the commodity shock brought about by Russia’s war in Ukraine contributed to red-hot prices. All played a part. How much, exactly, will be a subject for academic papers, dissertations and books in the years ahead.

Similarly, it’s not yet clear what has caused inflation to abate as much as it has — whether the Fed’s interest rate increases have mainly done it, for example, or whether the high rate of price increases really was largely transitory, though longer lived than anybody would have liked.

Traders in the stock market don’t seem to care what’s behind the recent disinflation. Enlivened by dreams of an artificial intelligence bonanza, they have been bidding up the prices of big tech companies like Nvidia, Apple, Meta (Facebook), Alphabet (Google), Tesla and Microsoft since the fall. As I wrote recently, cruise lines like Carnival, Royal Caribbean and Norwegian Cruise Line have been booming on pent-up demand from consumers eager to see the world in seaborne comfort.

At the moment, for the markets, the sky seems to be the limit.

Reasons for Concern

And yet, I worry.

The reasons for the decline in inflation aren’t merely of academic interest. If, for example, the Fed’s interest rate increases have not had much impact on the overall economy so far, that could simply be because they famously operate with “long and variable lags,” and they may yet bite — even if inflation has been coming down for other reasons.

Some painful effects are already discernible, however. High credit card rates are adding to consumer distress. Bond losses caused by rising rates have contributed to regional bank weakness. Costly mortgages have hurt housing and commercial real estate, while the work-from-home migration has shriveled office occupancy. How long that will last is anyone’s guess.

Interest rate increases this rapid and this large typically “lead to recessions,” Ian Shepherdson, chief economist of Pantheon Macroeconomics, warned in a presentation to clients this month. Credit tightening for small businesses caused by distressed regional banks hasn’t helped, either. Mr. Shepherdson isn’t saying there will definitely be a formal recession, but he said slower growth was coming.

The majority opinion on Wall Street is still that there will be a recession in the next 12 months, a Wall Street Journal survey this month showed. But because of the onslaught of data indicating that the economy remains in growth mode, many economists are lowering the odds of a recession happening, and expect that if one occurs, it will be mild.

Janet L. Yellen, the Treasury secretary, said on the sidelines of a Group of 20 economic meeting in India this week that in the United States, “growth has slowed, but our labor market continues to be quite strong — I don’t expect a recession.” But she has consistently taken an upbeat view of this issue, and it should be noted that Treasury secretaries tend to talk up the economy rather than warn about its weaknesses, especially when the presidents they serve face a re-election fight.

On the other hand, the minutes of the Fed’s June meeting indicated that its staff still expected a “mild” recession sometime this year. If the Fed — given that forecast — was convinced that inflation had already been vanquished, it would not raise rates at its July meeting. Yet the markets assume that it will do just that.

Furthermore, if anything causes an uptick in the inflation reports this summer or autumn — vagaries in the data, renewed energy and food supply shocks emanating from Eastern Europe, a surprising surge in demand in China, or anything else — the Fed could raise rates yet again later this year. In addition, the Fed says it intends to hold rates high well into next year, though at some stage will drop them to 4.6 percent.

I’d add that there have been negative tidings from gross domestic income, an official government measurement that has sometimes recorded economic downturns in advance of the more familiar gross domestic product. The discrepancy may mean nothing, or it may indicate that the G.D.P. statistics are painting too rosy a picture. It’s not certain yet.

In short, we have been experiencing a remarkably benign reduction in inflation — what is sometimes being called “immaculate disinflation” — and it is a wonderful thing. But because I don’t really understand it — and don’t believe that financial authorities do, either — I wouldn’t count on it. And I certainly wouldn’t base an investment strategy on it.

Recessions are a fact of life, and I wouldn’t be surprised if one turned up in the next year. In case of a downturn, I’m keeping cash in reserve but investing for the long haul. In the meantime, I’m enjoying the current, improbably pleasant state of affairs, as long as it lasts.

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