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November 6, 2022
What will the Fed do? This is the question that every Financial Advisor has found themselves asking more frequently this past year. A question that, given the correct answer, is the holy grail to investing for the foreseeable future. A question people all around the world are trying to take educated guesses on in pieces that, when printed out, are thicker than the Accounting Desk Book or your child’s Harry Potter book collection.
A question more easily answered, which is exactly what I will do in less than 1000 words.
The Fed had their November meeting two weeks ago where they discussed the current state of the economy, inflation, the jobs market, and everything in between. As the Fed does after every periodic meeting, they released a statement shortly before Fed Chair Powell held a press conference. Markets perceived the initial statement as leaning “dovish,” or pointing towards a pivot away from their current pace of rate hikes, due to some new commentary around the Fed accounting for cumulative tightening of policy, the lags that come with that tightening, and ongoing economic and financial developments.
Once the conference began, however, Powell’s commentary slowly became more and more adjacent to what we’ve heard in the past few meetings as things took a turn to what many investors have deemed “hawkish,” or pointing towards continued monetary tightening. It was eventually clear there would be no pause or substantial slowdown (i.e. less than 50bps) in hikes this year as Powell hinted that the terminal rate may be higher than previously expected.
Chair Powell began his speech with the same boiler plate language he has for the past few meetings:
“My colleagues and I are strongly committed to bringing inflation back down to our 2% goal…”
“Price stability is the responsibility of the Federal Reserve, and serves as the bedrock of our economy…”
“Longer term inflation expectations remain well anchored, but that is not grounds for complacency…”
The terminal rate is the rate that is viewed as the peak where benchmark interest rates will come to rest before the Fed begins trimming back. In a perfect world, it would be the rate where the Fed is comfortable sitting at while they watch inflation cool down before any possible turmoil hits the economy or jobs market. Prior to this Fed meeting, many believed that rate to be slightly under 5%. Now we may have eclipsed that number.
Powell then took a dovish turn by saying, “Decisive evidence of slowing inflation is not the bar for slowing the pace of rate increases.” He continued on by explaining, “The time to downshift to a slower pace of hikes may come as soon as next meeting, or the one after that.” This was all investors needed to begin licking their wounds from his extended terminal rate commentary.
When asked if inflation is becoming entrenched, Powell explained that short term expectations of inflation rising may work their way into wages eventually, but that long term expectations of inflation show stability. Ultimately, he concluded that there is no scientific way to assess if inflation is becoming entrenched.
What exactly is entrenched inflation and why is it such a bad thing? Inflation becomes entrenched as it works its way into the balance sheets of businesses around the country. As the things we buy begin to cost more, people need more income to purchase them. So those people naturally ask their employer for higher wages. Those wages are now an inflated cost on their employer’s income statement. As the things the employer wants to buy or invest in begin to cost more, they need more money for expenses. So, the employer will charge their customers to pay more for those inflated costs. Now, if they can successfully do that is a discussion for another piece. And that dynamic has the potential to build on itself in an endless circle, short-circuiting only in the event that there is a change in the balance of supply and demand. But this again is a conversation for another time.
Powell went on to speak about his thoughts around the lag of monetary policy and how the Fed looks at it. He explained that old theories say monetary policy acts with long and variable lags, but new literature suggests financial conditions act well before monetary policy decisions. This makes sense to the 21st century investor – America is more interconnected and data-driven than ever. Expectations of what might happen have just as much impact as what actually does happen. And so, it’s highly uncertain how quickly the economy adjusts to financial tightening, but at least the Fed acknowledges they are aware of the dynamics.
The market ultimately came down by the end of the press conference after Powell struck another hawkish tone, saying “It’s very premature to be thinking about pausing hikes, we have ways to go.”
The market seems to think a 50 basis point hike is the likely result for the next December Fed meeting. We have one CPI print between now and then which will likely weigh heavily on their ultimate decision. We can’t tell you with 100% certainty what they will do, but we can watch the data and react appropriately as rational investors.
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Sawyer is an Associate in our Boston office where he serves as a research analyst conducting due diligence, security selection, and trading for firm's equity...
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