Can’t Hurry Doves
Before this Fed meeting, the market had priced in a zero percent chance of an interest rate hike in September, and the market was right, rates remained unchanged. This was also one of the quarterly meetings when we get an update on the dot plot (a chart of all FOMC committee members’ projections for the fed funds rate, below), and a new summary of economic projections.
This is the dot plot for 2023 showing the change in expectations from prior meetings, and the current median expectation for a fed funds rate of 5.6% by year end. That suggests one more hike in either November or December. Not shown is the dot plot for 2024, which indicates a median fed funds rate of 5.1% by year end, thus suggesting two cuts at some point next year.
Both the 2023 and 2024 dot plot charts show a similar pattern of rising dramatically over the last year and a half. The takeaways I have from these data sets are: 1) inflation was and remains high, and troublesome, 2) the dot plot is not very good at predicting where rates will be, 3) the Fed is not going to forecast a recession in its rate predictions.
Where does that leave us as investors? Just as data-dependent as the Fed is, and with the knowledge that the onus for risk-management in our portfolios is on us, not them. One of the biggest risks I think we’re exposed to as investors is the conditioning that the Fed will save us from severe drawdowns.
Hurry Up and Wait
There’s so much anticipation for these meetings, especially when we have a month break in between. Often the actual announcement is anticlimactic, and recently the commentary has been rather boilerplate, which leaves us digging for signals in things like the tone of Powell’s voice or the color of his tie.
The quarterly gift we receive in the form of updated economic projections can be much more interesting. Well, interesting relative to the color of his tie, which is usually purple. This quarter, the projections moved slightly, as illustrated below. The Fed now expects stronger growth and lower unemployment both this year and next, and slightly cooler inflation this year with steady inflation next year as compared to the prior projections.
We can look at this and interpret it as positive — economy stronger than expected and inflation cooler or as expected. My concern is whether these projections are consistent with the current environment.
Meaning, if the goal is to get inflation back down to 2% — a goal that was reiterated multiple times today by Chairman Powell — we will very likely need to see a period of below-trend growth. In that case, margins are likely to be compressed further, putting pressure on company spending, and in turn, labor costs.
Take that concept even further, and if companies have to start cutting labor costs, consumers may stop feeling as confident and pull back on their spending. And so on, and so forth. That’s only one perspective based on growth expectations, but I still don’t think we’ve seen all of the effects of rate hikes. I know I keep saying that, but only because I keep believing it.
The Carrot Is Further Away
…but it’s still a carrot. I don’t know if this cycle really is longer, or if we are just more impatient. In either case, there are some signals that are indisputable. One of those signals is the Fed’s preferred yield curve spread, called the near-term forward spread (NTFS). The NTFS measures the difference between the expected 3-month interest rate 18 months from now and the current 3-month yield. When this measure is inverted, it serves as a reasonably reliable recessionary signal, as illustrated in the chart below.
The NTFS isn’t the only troubling indicator, but it’s an important one. It’s in decidedly worrisome territory, and has been since November 2022.
A stronger economy can fend off some of these restrictive measures for a while, but at some point a victor will emerge, and there’s still no telling whether the stronger-than-expected economy or the restrictive environment will come out on top. We’re all rooting for the economy to win the fight, but warning signals and what history suggests about aggressive tightening are putting up a heckuva fight.
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