Wealth Insights | Weekly Market Analysis | Economy | Asset Allocation | Equities | Fixed Income
Weekly Market Analysis - The US Federal Reserve That Doesn’t Stand Still
Posted on3 Things to Know
The Fed Plays Defense
Last week, global markets anxiously anticipated key updates on US monetary policy and continued to react negatively to surprising political developments, particularly in France (please see Europe: Electoral Implications). Fed Chairman Powell defended both the Fed’s steady monetary policy this month and the central bank’s outlook for rate cuts over the next 2-3 years.
And is Deliberately Cautious
The Fed deliberately sets monetary policy at “accommodative” or “restrictive” levels to manage US employment and inflation. Both represent deviations from long-term sustainable interest rates. US monetary policy is far more “activist” than in other regions. This partly reflects the greater variability in US employment. Having taken responsibility for the Great Depression, the Fed is careful to avoid deflationary monetary policy, even as inflation targets were badly missed in recent years.
AI Is an Energy Transformer
Much has been written about the power-hungry nature of AI to disrupt progress on corporate and national goals of energy transition. But the technology itself also offers potential opportunities to save perhaps even more energy and shift energy demand to locations where supply is abundant, evening out demand in grids around the world. AI also has the potential to address a growing number of challenges including energy, food, water, and waste management. Here the magnitude of the problem gives a sense of the scope of opportunity.
Summary
Last week, Fed Chairman Powell had the unenviable task of defending the Fed’s current monetary policy stance, its plans to reduce interest rates during the next two-to-three years, and the seeming discontinuity of it all within the Fed’s updated economic forecasts. Just as the US reported a flat month for consumer prices and a downside surprise in the core CPI, the Fed released its Summary of Economic Projections (SEP) with upgrades to the inflation forecast for 2024.
When Powell was questioned about the Fed’s projections for a single rate cut within 2024, he noted the addition of more cuts to the Fed’s projections in 2025. This simply signaled delay, not a real difference in the Fed’s outlook for rate cuts. The Fed still expected it will take its key policy rate down to 3.1% by the end of 2026. In conclusion, we believe that once the Fed decides inflation risks are clear, it will begin a process of cutting rates, perhaps routinely by 25 basis points. This is in line with its history of sustaining increases and cuts over a span of many meetings. Barring an economic catastrophe, the Fed will not bring rates back to zero.
Portfolio considerations
Some of the Fed’s new economic projections were out of date on their first day of release. The bond market is still pricing in some probability of a Fed rate cut by September (65%) and one further step before year end. We think the probability of Fed easing is even higher. US stock/bond correlations have come down since the “Fed shock” of 2022. We continue to argue for intermediate-duration bond positions to lock in solid yields for longer than the Fed will remain tight. Global political developments also argue for allocations.
Source: Haver Analytics as of June 12, 2024. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events
The Fed Plays Defense
Under questioning, Fed Chair Jerome Powell noted that Federal Open Market Committee (FOMC) participants were given the chance to alter their forecasts on Wednesday morning after seeing the new CPI data. Pushed further, his response was “most people don’t.” In essence, observers are splitting hairs over minor deviations in data subject to significant “randomness,” sample-based errors, and yes, the limitations of human forecasters. Is 2.6% measured inflation really different from 2.8%? If you understand the survey samples and data construction process, we think you’ll agree with us: it’s virtually nothing. More materially, as detailed in last week’s CIO Bulletin and Data Watch, readings on the economy are now unusually conflicting. The gap between employment growth reported over the past 12 months in the survey of employers and the survey of households is at a record. Despite month/month volatility, we think evidence suggests a slowing in US employment growth is underway. In contrast, US monetary policy has done nothing but tighten in the past two. Asked why the Fed would consider easing monetary policy, Powell explained that the current level of US interest rates is restrictive, meaning that “the economy would weaken without cuts.
Many observers have difficulty understanding why the Fed doesn’t just set US interest rates at levels it believes can be sustained for the longer run. Instead, the Fed deliberately sets monetary policy at “accommodative” or “restrictive” levels to sway inflation and employment. These settings are, by definition, not meant to be stable.
And Is Deliberately Cautious
Central banks can target 2% inflation, but when they “miss,” there isn’t a working strategy to make up for it with a below-2% target. The Fed, for one, won’t sustain a deflationary monetary policy after taking responsibility for the Great Depression of the 1930s. While data for the month of May showed a strong gain for employment at US establishments, one risk Powell noted was that “The labor market has the tendency sometimes to weaken quickly. So, waiting for that to happen is not what we’re doing.”
In conclusion, we believe that once the Fed decides inflation risks are clear, it will begin a process of cutting rates, perhaps routinely by 25 basis points. This is in line with its history of sustaining increases and cuts over a span of many meetings. Barring an economic catastrophe, the Fed will not bring rates back to zero. But there is good space to cut from 5.25%-5.5% – the current policy range – and what the Fed views as “longer-term normal.” With an update, the Fed’s new projection of this is 2.8%. We sense this estimate is still a bit too low. But unlike the 0.2% differences in inflation readings we mentioned, the gap between 3% and 5.5% for the Fed’s policy rate is far from trivial.
AI is an Energy Transformer
The potential applications of AI are vast and include faster drug discovery, precise medical diagnoses, personalized learning, disaster prediction and response, streamlined supply chains, increased agricultural yields, and improved customer service. AI’s ability to optimize processes, accurately predict demand, and make data-driven decisions can also enhance society’s efficiency in managing energy, food, water, and waste. Applying AI-powered innovation to address societal challenges has the potential to maximize economic value while minimizing ecological footprint.
Currently the AI revolution has the character of a gold rush and we see one way to invest in the space remains in mega-tech leaders, AI infrastructure, and to a lesser extent AI end users. In addition, we believe a compelling subset of potential opportunities in our ongoing AI-propelled digitization unstoppable trend include companies that are creatingand/or employing solutions to sustainability challenges.
There is a class of problems that have been too costly or labor intensive for companies to address. These challenges tend to be less glamourous and are frequently neglected because the cost of solving them exceeds the value generated. For example, identifying individual strawberry plants with pests for hyper-localized and low waste insecticide application, or distinguishing which items in a generic stream of rubbish have enough copper that they’re worth salvaging at today’s market price. Addressing these problems often requires analyzing large, diverse, and unstructured visual datasets while making frequent, incremental decisions. The era when specialized solutions were painstakingly developed for specific contexts, often at a considerable cost, is behind us. Today, AI can create solutions for generic problems and adapt to shifting inputs at an unprecedented rate. As a result, these challenges are increasingly resembling avenues to boost profitability while maintaining competitive pricing.
