Fed Policy Will Have to Stay Tight for A While

Many analysts are prematurely sounding “all clear” and declaring we’ve seen the worst effects of the Federal Reserve’s tighter monetary policy.

It is understandable. We haven’t had a full Fed tightening cycle in many years. Long-term factors kept a lid on inflation for about 20 years, allowing the Fed to ease policy whenever the economy or stock market needed a boost.

But persistent and high inflation in 2022 ended that era. Fed policy changes roll through the economy in waves, affecting different sectors and markets at different times. The more speculative and leveraged sectors react first, while others feel the effects after lags.

The process can take 18-24 months, sometimes longer. In this cycle, some lags are longer than usual.

Households and businesses went into the tightening cycle with stronger balance sheets than in the past. Private sector debt and debt service gradually declined following the financial crisis. The massive stimulus during the pandemic also improved balance sheets.

That made households and businesses less sensitive to higher interest rates and falling prices of financial assets and homes than in the past.

The results are the economy is more robust than usual after a Fed tightening, and inflation has been more persistent. The Fed will have to continue a tight monetary policy, because inflation isn’t likely to reach the Fed’s target without lower growth and incomes.

If you’ve followed Bob’s Journal this year, you know that credit card debt use is increasing while delinquencies on consumer debts are rising.

Banks are tightening lending standards because they have losses on bonds and mortgages, thanks to higher interest rates. They’re also losing a lot of deposits upon which they were paying interest rates close to 0%.

The manufacturing sector is slowing, with the ISM Manufacturing Index saying it is in a recession and contracting.

Inventories are rising and unfilled orders are declining, both indicating demand is falling.

The labor market remains strong with compensation increases well above the average of the last 20 years. That’s a significant reason inflation is persistent.

But there are signs the job market is past its peak. The unemployment rate is up, and job openings are below their highs.

Hidden in the data is that, unlike in the past, the slowing economy is hitting higher-income people first. New unemployment claims are concentrated in households earning at least $125,000 annually.

The highest compensation increases over the last year have been concentrated in lower-income occupations.

Higher-income workers are receiving increases lower than the average and below inflation.

Travel and hospitality continue to be the strongest sectors of the economy, while most other sectors are weakening.

Growth in retail sales has slowed. The Consumer Confidence Index is down and falling further, revealing pessimism among a high percentage of consumers.

Interest rates likely hit a short-term bottom in early May. The number of new federal bond issues artificially declined in the last year or so, but that’s going to end soon with a surge in Treasury debt issues for the market to absorb.

The stock indexes have solid returns so far in 2023, but the increases are concentrated in an unusually small number of stocks.

Most stocks are trading below their 200-day moving averages, and have negative returns for the year to date.

Stock valuations are extremely high, leaving little room for surprises or disappointments. Stock prices are likely to tumble if there’s a recession, earnings are disappointing, or the Fed doesn’t ease monetary policy as soon as expected.

Of course, there is also the potential that something significant in the economy will break. There are a lot of reasons it’s not time to sound an “all clear” signal.