QVMS - The Fed Needs To Avoid Sending Absurd Messages To The Market

Summary

• Too many people still think that the Federal Reserve needs to continue aggressively raising rates.
• There's no need for aggressive hikes.
• Surprising the market with larger hikes would be extremely foolish and reduce the Federal Reserve's credibility.

The market started 2023 with a substantial rally. As share prices climbed, some investors became concerned that the market may never crash to the levels they deem fair. In many cases, these investors may be sitting on cash or even in short positions hoping for lower prices. However, the Federal Reserve's mandate does not include "bail out all bears."

Dual Mandate

The Federal Reserve aims to keep inflation steady and to keep employment near the maximum "sustainable" levels. At least, that's what the mandate says.

It's far from perfect. The Federal Reserve didn't have the right tools to curb the type of inflation we saw in 2023. Specifically, they do not have the tools to increase supply or slash deficits.

Inflation Over a Year

The rate of inflation, as measured by the CPI (Consumer Price Index), already is falling:

Note: I'm using 3 different values for CPI because I want to separate out the "Shelter" value. The value for "Shelter" is severely lagged. Consequently, it smoothes out spikes in the data by being late. There are good uses for this lagged data, but determining macroeconomic policy is not one of them.

However, many bears will argue that it isn't down far enough yet. They will argue that the Federal Reserve should completely ignore the trend over the last few months and focus on where the value was a year ago.

In finance, that's similar to Anchoring Bias.

We need to continue including new information as it comes in.

Looking back to 2021, you may recall that the Federal Reserve was refusing to raise rates until long after most investors saw that inflation was a serious problem. Their refusal to raise rates wasn't such a large problem in itself. It was their argument for why they were refusing to raise rates.

The Federal Reserve argued that inflation was transitory. The problem is that there wasn't a great consensus among people about what qualifies as "transitory." The definition most people used would suggest that inflation was not transitory.

Inflation Today

Rather than using the CPI charts based on the reading from one year ago, we can use charts annualizing the last monthly reading. The result will be a bit too volatile for individual months. However, as long as you recognize that a single value may be off, you can use it to spot trends.

We're still measuring the CPI growth rate, but that's a dramatically different chart. When we look at it this way, some months spiked to 15% or even 20% when we exclude the lagged shelter data. Even if we normalize for those spikes a bit (such as averaging three adjacent months), it still shows that the real spike was around the early to middle part of 2022.

It also demonstrates that the rate of inflation has absolutely plunged. Starting with July 2022, the average rate of inflation, excluding lagged shelter data, is negative.

Even if the CPI value bounces higher in the next report, it will still be a very low rate over the last six months.

An Alternative

One of the alternatives proposed for measuring inflation is Core PCE. We compared the year-over-year change with the annualized value (just multiplying monthly by 12):

Is that a great tool? I think it's less useful than the CPI. Using Core PCE the highest annualized value was only a hair over 7.5%. Do you believe inflation was actually that low? Probably not.

So if you concur that Core PCE was a bad tool previously, it would be hypocritical to embrace it today simply because it creates a higher "inflation" rate.

What Should The Federal Reserve Do?

The best choice is to maintain credibility. No surprise for the market. Surprising the market would indicate that they failed to adequately deliver their points previously.

The current Federal Funds Rate is 4.25% to 4.5%.

The market has a very strong consensus forecast for where rates will be after the next meeting:

That's a 98.1% probability for a range of 4.5% to 4.75%. In other words, the market is overwhelmingly indicating that a 25 basis point hike is expected. There's no reason to damage their credibility by surprising the market.

Outlook

We're up a bit over 12% month-to-date. It's been a great January, but it's also been a bit sad to see some of our favorite bargains rallying. Overall, I still think there's quite a bit of room to run in the sectors we cover. I've been arguing that when the market realized inflation was dead, it would create a significant boost to valuations. That happened in January. The market finally recognized that inflation is dead, and the Federal Reserve is expected to catch on over the next few months.

Since interest rates tend to have a delayed impact on the economy, continuing to push rates higher would create a high probability of overreacting. That's bad. That's how governments drive a boom and bust cycle.

To be fair, I don't give the Federal Reserve credit for taming inflation. I give that credit to the free market. Ask yourself which is more likely:

1. Billions of individuals across the world, each guided by their own best interest, adjusted their production and consumption demonstrating that capitalism conquers inflation.
2. A government-appointed official solved inflation by paying out higher interest rates.

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