Markets Fight the Fed

The markets are fighting the Federal Re- serve, making the Fed’s job harder and increasing uncertainty about the economy and markets. Fed officials openly stated they’re serious about controlling inflation, and backed the words with action, rapidly raising interest rates and reducing the Fed’s balance sheet.

The more actions the Fed took, the more optimistic investors became. Stock indexes moved unsteadily higher from the lows of October 2022, then began an almost uninterrupted climb after February 2023. Market interest rates fell after October 2022, though they recently moved back near last fall’s high.

Home prices have been strong despite higher interest rates. These moves in the financial markets typically follow an easier monetary policy, not a tighter one. The optimism in the markets makes it harder for the Fed to bring inflation down to its 2% target.

Higher prices for stocks and homes make households wealthier, giving them more confidence and making them more likely to spend. Confidence and spending support higher prices. Also making the Fed’s job harder is that the labor market remains tight.

There still are many unfilled jobs, and unemployment is low. The economy continues to grow, especially in most of the service sector. Wage increases remain above multi-decade highs and are inconsistent with inflation of 2% or less. In fact, after the recent decline in inflation, average wages are rising faster than inflation, giving households a real net income in- crease and more money to spend. That sustains inflation.

Nonetheless, inflation has declined significantly from its 2022 peak, and that was expected. Several disinflationary forces helped reduce inflation from its peak. The worst of the supply chain pressures are behind us. Also, energy and commodity prices tumbled from their elevated levels because of reduced demand and some supply increases.

China’s suspension of zero-Covid policies was expected to increase global demand and put upward pressure on many prices. But China’s growth rate remains low because of high debt levels, overbuilding in key sectors and many government policy changes. This lower-than-expected growth in China reduced the pressure on prices of many commodities. But the disinflationary factors are one- time events rather than persistent forces. In early 2023, U.S. growth appeared to slow a bit in response to the tight Fed policies only to move higher more recently. Prices of energy and a number of other commodities bounced off their recent lows.

Stock and home prices rallied. Job growth increased after showing signs of slowing earlier in the year. The Fed suspended its tightening policy briefly because of the banking failures that occurred in the spring. But that crisis seems to have passed, and the Fed resumed shrinking its balance sheet and raising interest rates. Sustained demand, especially for services, makes it likely that inflation will stabilize above the Fed’s 2% target. Inflation probably won’t decline further unless demand is reduced by lower economic growth and incomes. Stock prices don’t reflect the prob- ability of lower growth and incomes.

They also don’t recognize that earnings growth and profit margins are likely to be reduced by the higher wages paid by employers. Market prices indicate investors be- lieve inflation soon will reach the Fed’s target and shortly after that the Fed will start reducing interest rates. But it’s more likely inflation will settle in a range of 3% to 4%.

Even if inflation does come close to the 2% target, the Fed is unlikely to begin reducing interest rates. Lower rates and easier monetary policy would stimulate demand and rekindle infla- tionary forces. The higher probability is that interest rates will stay at or near recent levels for an extended time, absent a significant decline in the economy.