The Stumble in the Fed Pivot

Expectations about interest rates and inflation changed quite a bit in the first five months of 2024.

In January, investors believed the Federal Reserve would reduce interest rates at least six times, a move known as the Fed Pivot. By April, the consensus saw only two rate cuts, and a growing number of investors wondered if rates would drop at all.

In his comments following the latest Fed meeting, Chairman Jerome Powell felt the need to say it was unlikely the Fed would increase interest rates during 2024.

The turnabout occurred because the economy maintained a solid growth rate despite the historic interest rate increases during 2022 and 2023.

Normally, significant interest rate increases reduce economic growth, usually leading to a recession.

But this cycle really was different.

The growth that preceded the interest rate increases wasn’t fueled by businesses and households taking on more debt. Instead, the government expanded its debt, the Fed bought most of the debt, and the proceeds were pumped into the economy.

Rising interest rates had little effect on the economy because consumers and businesses weren’t highly leveraged. In fact, many improved their balance sheets thanks to the pandemic stimulus.

The pandemic stimulus continues to flow through the economy. Many businesses still report solid demand from customers and say they plan to expand. Hiring enough qualified workers remains a top concern of many firms.

Some economic data has been weaker, but overall growth remains at a level that makes it unlikely inflation soon will decline to the Fed’s 2% target.

The economy’s strength is most apparent in household income and spending.

Compensation increases remain above the average of the last couple of decades, supporting household spending growth. While retail sales and household spending are volatile from month to month, they appear to be settling at about a 5% annual growth rate.

Businesses say they plan to increase their capital expenditures, indicating they believe consumer spending growth will continue.

A year ago, most forecasts anticipated a recession in late 2023 or early 2024. Instead, real (after inflation) GDP growth seems likely to average around 2%, and inflation will hover around 3%.

Inflation peaked in June 2022. Part of that inflation spike was from supply chain problems and pandemic-induced imbalances between demand and supply.

Normal economic forces resolved those issues and did the easy part of reducing inflation.

But the sustained economic growth makes it harder to reduce inflation the rest of the way.

Further tightening by the Fed or another action that reduces income growth is needed to bring inflation to the Fed’s target.

Many investors and analysts believe the Fed is maintaining a tight monetary policy since it hasn’t reduced interest rates yet. They’re wrong.

As I’ve pointed out before, the Fed resumed increasing the monetary base in early 2023. The growth continues, though at a lower rate than in 2023.

In addition, the Fed announced it would slow its quantitative tightening policy. Under the change, the Fed won’t reduce its balance sheet as rapidly as previously announced.

The Fed has a tough balancing act. The U.S. Treasury needs the Fed to buy some of its bonds. Otherwise, interest rates would have to spike higher to attract enough private buyers for all the debt to be issued.

But that would inject more money into the economy, possibly reigniting inflation and even embedding it in the economy.

Inflation isn’t going to drop to the 2% target without a fight.

That’s not good for bonds and some overvalued stocks But the environment should be good for many stocks and some other assets.