06.14.2023 Federal Reserve policymakers convene again this week to decide the direction of monetary policy. Investors are wringing their hands over what the Fed’s decision might be. Will the Fed pause, skip or hike? What should be done and what will be done might differ. Cresset is firmly in the “pause” camp – we believe the Federal Open Market Committee should leave rates alone and not raise them again this cycle. The case for a Fed pause is manifold.
Starting in March 2022 (arguably late, in retrospect), Powell & Company embarked on one of the most aggressive rate-tightening programs in more than 40 years. The FOMC ratcheted up interest rates by five per cent in just over 12 months. The housing market quickly reacted to higher rates: existing home sales plunged by 45 per cent. Other parts of the economy, like the jobs market, will be slower to react. History suggests that it takes between one and three years for the unemployment rate to peak following a peak in the overnight rate.
Turmoil in the banking sector, an unintended consequence of the Fed’s policy, began in early March and culminated in the failure of Silicon Valley Bank and Signature Bank. US banks, large and small, lost nearly $700 billion in deposits since the Fed’s program began. The deposit run forced banks to reduce their loan books and tighten credit standards, in effect magnifying the Fed’s liquidity reduction. Lending standards have tightened to recession levels by historical standards. The impact of higher rates and tighter credit has not yet filtered through the commercial real estate sector, for example. But with $1.5 trillion in commercial real estate debt coming due by the end of 2025, it will.
Fed policy hawks have argued that you can’t break the back of inflation without killing wages. That view has evolved, as Fed officials reassess their view that wage gains cause inflation and not the other way around. Policy was originally fueled by the belief that wages make up a substantial cost of services and therefore drive services prices. However, new research suggests the link between wages and inflation isn’t as strong as previously believed, and so further tightening would run the risk of unnecessarily weakening the labor market. Increased evidence indicates that wage growth follows inflation and expectations of inflation. Fed Chair Jerome Powell is a convert: “I do not think that wages are a principal driver of inflation,” he articulated in early May.
Fed officials also realize that standing pat on rates is tantamount to tightening in an environment in which inflation is trending downward. That’s because the “real” Fed Funds rate – the nominal rate minus inflation – will continue to rise as inflation falls, creating incremental tightening. Yesterday’s CPI reading, at four per cent over the last 12 months, falls lockstep into its slowing trend. A three per cent CPI means the real Fed Funds rate would be 2.25 per cent, its highest level since the financial crisis.
An overly aggressive Fed is the biggest risk to the market and economy as persistent inflation forces the Fed to continue to tighten, damaging profits, jobs and growth. From an inverted yield curve to moribund business sentiment, recession signals abound. Nearly two-thirds of economists surveyed expect a recession over the next 12 months, according to Bloomberg. The downside risk of a Fed-induced recession dwarfs the possibility of inflation trending lower for longer.
A Fed pause would be welcome news to investors. Steady overnight rates would signal light at the end of the tightening tunnel. We expect a June pause would usher in a shift in market leadership, with small caps and regional banks leading large caps higher. We also expect the dollar, which is expensive against most currencies of our trading counterparts, would roll over as investors balance a Fed in neutral against a hawkish BoE and ECB. Dollar weakness would represent a tailwind for gold and non-dollar developed market equities.