How Investors Undermine Their Forecasts

Investors have been on a roller coaster ride of their own creation for the last couple of years.

Each time inflation cools and the economy slows, investors become ebullient. They conclude the Fed is about to cut interest rates rapidly and significantly.

That anticipation of easy monetary policy leads to reduced interest rates and lifts the prices of stocks, bonds and homes. Stock prices have been the biggest beneficiaries.

Higher asset prices make consumers wealthier, and that changes their behavior. They spend more, a phenomenon known as the wealth effect.

Higher consumer spending increases economic growth and keeps a floor on inflation. Higher growth and inflation make it difficult for the Fed to ease monetary policy.

When in December 2023 the Fed announced that it expected to reduce interest rates several times in 2024 (though less than markets were forecasting), the expectation was based on certain levels of economic growth and inflation, which officials listed at the time.

But the wealth effect quickly pushed growth and inflation above the levels the Fed anticipated, and recent trends indicate they’re likely to increase further. Fed officials quickly made statements tempering the December 2023 forecast. Market interest rates rose again.

Investors have taken us on this roller coaster ride since early 2022. Forecasts of easier monetary policy led to higher asset prices, which led to stronger growth and higher inflation.

Continuing federal government spending and deficits also boosted growth and delayed interest rate reductions.

Part of the problem is a misunderstanding about the two types of inflation that occurred in 2021 and 2022.

The supply chain disruptions and demand/supply imbalances were easy to identify as major reasons why the 12-month inflation rate exceeded 8% at its 2022 peak.

Those inflationary pressures were concentrated in goods and physical products. The supply chain pressures, and demand/ supply imbalances gradually eased during 2022 and 2023 and now largely are resolved.

We see that in recent inflation reports, which show low inflation or deflation in the prices of most goods and commodities.

But the federal government’s pandemic spending, and the easy monetary policy that funded it, caused normal cyclical inflation.

Historically, the tight monetary policy the Fed began to implement in 2022 would have reduced the cyclical inflation and then some, perhaps causing a recession.

But this isn’t a normal cycle.

Households and businesses entered the tightening cycle with strong balance sheets. Unlike past inflations, this cyclical inflation wasn’t caused by excess business and household borrowing. It was caused by high levels of fiscal spending financed by the Fed.

The tighter monetary policy didn’t reduce cyclical inflation in line with historic norms because higher interest rates didn’t cause businesses and households to reduce spending. They had a lot of cash and low debt levels.

That’s why, despite much higher interest rates, the recent monthly inflation data show services inflation remains fairly high and more than offsets the decline in goods’ prices.

The consumer is financially strong and spending, and that supports economic growth. Solid economic growth keeps wage increases above their average level of the last couple of decades and makes it unlikely inflation will hit the Fed’s 2% target and stay there. In fact, strong wage growth could end the decline in goods’ prices.

The Fed knows that if it eases monetary policy as much as the markets expect, inflation will surge. With a recession unlikely in the near term, the Fed knows the risks of easing monetary policy are greater than the risks of maintaining its fairly tight policy.

Recently, bonds gave up about half of the gains earned in November and December, because investors started to recognize the Fed can’t cut rates as much as anticipated.

Despite higher interest rates, stock prices can keep rising if earnings meet expectations, especially for stocks that lagged the indexes in 2023.