Where Will the Fed Go Next?

Caleb Stevens: Well, hey everybody, and welcome back to The Community Bank Podcast. I’m Caleb Stevens, and today I am joined by Mr. Tom Fitzgerald. Tom, you sat down with Joe Keating to get his regular update that he provides here on the show on all things related to the economy.
Tom Fitzgerald: I sure did, Caleb, and I think that our listeners will enjoy hearing what Joe has to say about not only where are we going with the GDP, where are we going with inflation, where are we going with interest rates, and also where are we going with stocks. So I think it’s a well-rounded discussion and I think the listeners will enjoy it.
Caleb Stevens: Well, without further ado, we’re going to go to that right now. Thanks for joining us.
Tom Fitzgerald: Well, Joe Keating, it’s great to welcome you back to The Community Bank Podcast. I think you’re our most frequent guest and it’s easy to see why with all of the happenings in the economic world. Our listeners, I’m sure, really look to your insight and your thoughts on the economy and the markets as a whole. So just want to welcome you back, Joe.
Joe Keating: Thanks, Tom. And I’m honored to be part of the program.
Tom Fitzgerald: Well, as usual, as the case may have it, we always seem to have more questions than time that we are allowed. So I’ll just hop right into it, if that’s okay with you.
Joe Keating: Sounds good to me.
Tom Fitzgerald: Last time we got together, Joe, it was early October. You had described the economy as sort of flat-out stalling and that the risk of a short and mild recession had increased for ’23 as the Fed continues its rate hiking campaign to tighten policy. Is that still your perspective as ’23 looms on the horizon now?
Joe Keating: Well, Tom, the short answer is yes. The data points to a flat-out stall in the economy’s growth rate, and I’ll cover that, with certain sectors doing well and others in recession or close to recession. The overall economy is not in a recession when you consider that we’ve had monthly average job gains so far of 443,000 and industrial production is up 4% on the year. Now, the economy could experience a short and mild recession during 2023, more of a technical recession, but we continue to see little chance of a deep and prolonged recession. Since we got together, the Bureau of Economic Analysis released the third quarter data. In fact, it was updated this morning, and third quarter real GDP was reported to have grown at a 2.9% annual rate. However, that number materially overstated the underlying growth rate in the economy during the quarter.
Net exports added 2.9 percentage points to the quarter’s growth rate with exports growing at a pace in excess of 15%, largely more oil and natural gas being exported because of the war in Europe while imports fell at a pace a little bit greater than 7%, as households pulled back on their purchases of imported goods. Without the boost from net exports, real GDP would’ve been tabulated at zero for the quarter. So stall.
Possibly a more accurate representation of the economy’s growth rate last quarter was the one half of 1% rise in real domestic private final sales, which as you know, Tom, is the sum of consumer spending, business capital spending, and residential construction outlays. The key insights in the third quarter data are the shifting demand in the economy and the impact the tightening of monetary policy is having. Real consumer spending grew at a pace just less than 2%. However, outlays for goods were basically flat. They actually fell two-tenths of 1% while spending on services grew to pace at almost 3%. The shift in household outlays from goods to services is happening, and that’s helping to balance the shortage gap between supply and demand for goods that developed as the economy reopened following the pandemic. The tightening of monetary policy is also negatively impacting the demand for goods, as we all know, an explicit goal of the Federal Reserve. The formerly red-hot housing market has entered a serious recession as the combination of sharply higher mortgage rates, as we all know, they’re slightly under 7% now. They were just over 3% at the start of the year. On top of the pandemic housing boom, that pushed home prices up on the order of 40% over the two years following January of 2020, which combined, crushed housing affordability to a 15-year low.
So we saw residential construction outlays in the third-quarter plunge at a pace of almost negative 27%, the sixth consecutive quarterly drop. This data is consistent with other measures of housing activity with single-family housing starts down 35% since December, new home sales lower by 25% since December, and existing home sales down by 32% since January. Again, this is an outcome the Federal Reserve has sought. Business capital spending led the economy last quarter, growing at a pace just in excess of 5%. However, structure outlays fell at a pace close to 7%, also the sixth consecutive quarterly drop, while equipment outlays grew at a pace pretty close to 11%. These trends are consistent with a post-pandemic state of the economy and the collapse in structure outlays is once again in line with the Federal Reserve’s policy initiatives. The bottom line is the economy, in general, has stalled under the weight of elevated inflation which has really hurt real wages with the interest rate-sensitive sectors of the economy bearing the brunt of the slowdown. The Federal Reserve should be encouraged by this data as they consider policy going forward.
Tom Fitzgerald: Okay, let’s turn now, Joe from a growth perspective to the inflation perspective. And it’s interesting, when we last met in October, we had set up for a series– It looked like inflation had peaked in kind of the second quarter range, and then we were getting a series of lower reads on inflation. And all of a sudden, that September report came and kind of spoiled the party. And I think at our last podcast on the show, you had talked about that quote, that, “Not all hope for a lower inflation was lost despite the hotter than expected September inflation report.” And sure enough, the October report came out and it was actually cooler than expected. So do you think we’re on that cusp of a series of inflation readings that do show inflationary pressures are easing?
Joe Keating: Tom, I do. And it’s interesting that prior to the October report on inflation, evidence of lower inflation was everywhere except in the reported inflation data. Consider that, and these numbers today are not that different than what we were seeing back in October, but industrial metals commodities are down 35% since March. Industrial commodities are down about 20% since May. Retail gasoline is down 30% from June. Futures for gasoline are down about 45% since early June. Lumber, given what’s going on in the housing market, is down 74% since early March. And as an input to the apparel side, cotton is down 50% since then. So, as you mentioned, the October CPI report cooled more than expected to its slowest pace since January.
And here’s the real key to that number. Reflecting the shift in the trend of consumer prices, the annualized four-month rate of change in the CPI was 2.8%, whereas over the four months prior to that, it was 12.2%. So a marked slowdown over the last four months. Helping to bring that inflation measure lower was a 2.4% decline in used vehicle prices, which is the result of a 21% rise in new vehicle sales over the past 13 months, which that used vehicle prices led the inflation spiral up and has shown progressively larger declines in the past three months. And a just slightly less than 1% drop in apparel, which is reflecting efforts by retailers to reduce outsized inventories. Prices for medical care services fell six-tenths of 1% from September as the labor department updated its price index for health insurance premiums. Whichever direction that update takes, prices tend to persist until the next annual update.
So, for instance, that annual update was reflected in the October CPI report, and it showed a 4% decline. Over the previous 12 months, it showed an average monthly gain of 2.1%. So we do think that last month’s CPI report should be the first of a series of inflation readings that show inflationary pressures easing. Goods deflation appears to have taken hold with supply chains loosening, imported consumer goods prices declining, used car prices as we talked about moving down rapidly, falling freight rates with supplier delivery times very close to pre-pandemic readings, and increasing new vehicle production and inventories. Additionally, the pace of increase of new rental leases has slowed considerably, although it has not shown up in the inflation reports yet, because the labor department’s measure of rents reflects what renters at large are paying, both those who just signed leases and those who signed them up to a year ago. As a result, it tends to lag behind changes in rents for newly signed leases.
There was also good news on inflation in the October producer price report and the big change in the data was that reflecting the shift in the trend of producer prices, the annualized three-month rate of change in core consumer prices decelerated from 10.6% in March to 3.3%. In October. The labor market slowing, which will free up some slack, will also reduce inflationary pressures. And as you know, Tom, we saw the ADP report come out this morning with a gain of 127,000 for November. What’s interesting, inside the report was goods-producing jobs were down 86,000 while service sector jobs were up 213,000. Meanwhile, excess inventories have led several major retailers to cut prices, and retailers, in general, are putting more items on sale as demand weakens.
Lastly, we should also note that the money supply is up one-tenth of 1% at an annual rate year to date, versus growing 40% over 2020 and 2021. In fact, the money supply dropped six-tenths of 1% in September, the largest drop for any month on record since 1959. So overall, if our forecast of the economy continuing to stall next year plays out, we would expect consumer inflation to approach two and a half to 3% by the fourth quarter of next year and could drop further by the fourth quarter of 2024.
Tom Fitzgerald: Wow. Joe, everything that you talked about sort of comes– You know, I do economic presentations every now and then and so a big part of my most recent presentations has been that difference that you see between wholesale pricing and what the consumer is still paying. And like you talked about, a lot of those items that you talked about, I had mentioned – lumber. You look at used car prices, you look at the cost of shipping, all of that has really kind of fallen off a cliff since June or so. But yet, the consumer has not really seen that. But it sets it up, I think, like you said, for probably a decent drop in inflation readings as we move through ’23. The other big thing too that I had noticed that you’re starting to get some real crooked big numbers coming off the year-over-year calculations starting with October, and that will continue into next year. And so I think if we get some decent monthly numbers, that that year-over-year number is going to drop as well, pretty significantly in ’23.
Joe Keating: I agree with that, Tom. And in fact, if you ask me what potentially could be the biggest surprise in the economy over the next few months, I would say that it could be a much unexpectedly lower rate of inflation relative to the consensus for the reasons you just mentioned.
Tom Fitzgerald: Yeah. And it’s funny. To kind of move to the Fed on the next part here, but the Fed, in their rhetoric, has been pretty consistent. They still just hammer away at inflation and they’re not willing to give an inch yet that what they’ve done and what they’re going to do is going to make some real improvements in the months ahead. And so they haven’t really budged yet on kind of giving a little bit more nuance to their inflation outlook.
Joe Keating: Correct. And, you know, Tom, I don’t think we’re going to see the Fed talk about pausing until possibly right before the meeting where they pause. They’re really trying to control expectations. And as we all know, we did get that fourth consecutive 75 base point hike on November two. And it was interesting that in the press conference, as you alluded to, Mr. Powell’s tone was more hawkish than not, making it clear that even though future rate increases might be smaller, they are likely to end higher and remain there for longer than was anticipated following the September meeting. It’s interesting that as Mr. Powell spoke, what had been a rally in stocks with the release of the policy statement turned into a route. Treasury yields rose and the dollar strengthened. Chair Powell repeated his view that it would be appropriate for the central bank to err on the side of raising rates too much rather than too little because he saw a bigger cost for the economy in allowing inflation to become entrenched. A sort of a read-through to his thinking was Mr. Powell’s assertion that it would be better to over-tighten and then repair.
So given the new language added to the policy statement, which was unanimously agreed to by the committee members, which emphasized taking into account the cumulative amount of tightening and the lags with which monetary policy works, we do expect, and I know you expect this too, Tom, the Federal Reserve to raise rates by 50 basis points at the upcoming December, 13, 14 FOMC meeting. You know, over the past couple weeks, the rhetoric of the members of the F OMC committee has coalesced around a slower pace of rate hikes with the debate moving to the expected peak in the target for the federal funds rate. We expect a further step down to 25 basis point increases sometime in early 2023, given how rapidly the economy is slowing, particularly in the most interest rate-sensitive sectors of the economy, and the moderation in the inflation reports that we’ve already talked about, that we expect. Given the amount of tightening the Federal Reserve has already undertaken, the pace of rate hikes becomes less important than the question of how high to raise rates and how long to keep monetary policy restrictive.
I think the main message we’ll continue to hear from the Federal Reserve, including from Mr. Powell later today, is that the key is higher for longer. The futures market for the federal funds raise is indicating that the target range for the federal funds rate will peak around 5%. So that’s interesting because is that 4.75 to five, or is that five to five and a quarter? So I think that that’s the ballpark of where the Fed is going to stop raising rates so the market just has it at five. That would be consistent with a 50 base point hike in December, possibly another on February one and a final 25 base point hike on March 22, or maybe no hike. So after reviewing the recent data on the economy and inflation, it appears that monetary policy has reached a level, and this goes back to our position that the economy has flat-out stalled, where it is sufficiently restrictive. That inflationary pressures could drop quickly over the next six months with the economy, as I said, flat-out stalling. This could set the stage for the Federal Reserve to start cutting rates in the back half of ’23 and possibly more rapidly in 2024. So the key is, in our opinion, the Fed is definitely in the late innings of their rate hiking cycle.
Tom Fitzgerald: And it’s interesting to know too, like you said, that most of the officials have been pretty adamant that whenever they get to that terminal rate, that they want to hold it there through ’23 and possibly into ’24. But I would just remind the listeners that it wasn’t much more than a year ago that the Fed was saying they didn’t see rate hikes until ’24. They didn’t think inflation was going to be an issue. Remember the transitory terms that they were throwing around? They didn’t think recession was going to be an issue. But yet, the events on the grounds kind of took place, and here we are. And I think as certain as they sound today, and as adamant as they sound today, that, like you said, if we get into a more softening in the economy, more than expected, and a softening in inflation, that some of that sternness that they’ve been talking about, keeping rates solid at through ’23, that could shift fairly quickly.
Joe Keating: It sure could, Tom. And we can all recall what happened during 2018 when we saw the low in the stock market on Christmas Eve after the Fed continued to raise rates beyond what we all felt they needed to, and the market felt, which is more important, that they needed to. And then they were expecting to raise rates through 2019 because we were “far away from neutral” according to Mr. Powell. And lo and behold, they stopped raising rates after that December ’18 hike and then actually were cutting rates during 2019.
Tom Fitzgerald: Yeah. it’s amazing how they can shift from one side of the boat to the other.
Joe Keating: Absolutely.
Tom Fitzgerald: Especially now with the COVID and all the one-off factors that have been impacting not only our economy but globally. So I don’t envy their job, but just like I was saying, as certain as they sound today, that could shift fairly quickly. Let’s move now, Joe, from looking at the economy as a whole to look at the markets and specifically the treasury market. The moves that we’ve seen recently have been pretty dramatic from the recent lows at the end of July, and then treasury yields recently peaked around November 8th and have dropped pretty sharply over the past three weeks. What is your message from the treasury market and what do you see treasury yields going over the next quarter or so?
Joe Keating: Well, that rise in treasury yields, as you mentioned, Tom, did continue to November eight following the rather hawkish FOMC meeting on November two, where the Fed emphasized that they were going to take rates higher and keep them longer to get inflation under control. However, the release of that cooler October CPI report that we already talked about on November 10, saw treasury yields collapse. In fact, the 2 Year Treasury note on November eight was 4.65 and the futures market was expecting a target range of five to five and a quarter by the second quarter of 2023 for the federal funds rate. However, the 2 Year Treasury yield fell 32 basis points following the CPI report to 4.33 with the futures market pointing to the federal funds rate peaking at 4.75 to five. Right now, the 2 Year Treasury yield is in between those two points of 4.65 and 4.33 at about 4.53.
And as I mentioned before, the federal funds rate futures market is basically forecasting a 5% peak in the federal funds rate. Likewise, the yield on the 10 Year Treasury note reached four 12 on November eight but fell 29 basis points to 3.83 following the CPI report and today is trading at about 3.76 to 3.77. It’s interesting that November, if things close where we’re at now, will be the first month to have lower 10 Year Treasury yields since July. Well, given what’s happened with the rise in 10 Year Treasury yields, but the far greater rise in 2 Year Treasury yields, the treasury yield curve is now inverted to the tune of minus 77 basis points, which is a significant degree of inversion and a 40-year high.
So we think the message from the treasury market is that the stall in the economy is likely to continue over the next couple quarters and that the risk of a mild recession has increased. There’s probably some risk of a hard landing but we think that is not the likely case. It’s interesting that where the S&P is trading right now, it’s about 4% lower than it was back on May 31, despite the Federal Reserve raising the target range for the federal funds rate by 75 basis points four times over the past six months. So stock prices have weathered the rise in rates since June quite impressively. And it appears that investors have turned their focus to the beneficial effects of the Federal Reserve tightening monetary policy as the implied 10 Year inflation expectations embodied in Treasury securities has fallen from May 31 for the 10 Year from 2.64 to 2.27, for five years, from just under 3% to 2.34, and from two years from just under 4% to 2.4%.
So we think the Federal Reserve is having an impact, and as I mentioned earlier, is approaching the end of the tightening cycle. We think 10 Year Treasury yields should trade between three and a half to 4% for the next couple quarters as the Federal Reserve shrinking its bond portfolio by 95 billion each month counters the expected slowdown in the economy and the continued easing of inflationary pressures. Look for longer data Treasury yields to decline towards 3% next year as inflation moderates and the economy’s forward momentum, as I mentioned earlier, stalls. The yield on 2 Year Treasury securities will fall later in 2023 in anticipation of the Federal Reserve moving to lower rates possibly by late 2023, if not early 2024.
Tom Fitzgerald: Well, let me finish up, Joe, like we always do with your outlook on we talked about the fixed income market. Let’s talk about stocks now. And we had a pretty good rally after October the 12th, and I guess the first question will be, why did that happen in your view? And also, just want to follow that up with, do you feel the bottom is in? That the lows that we saw in mid-June, is that it for the selling? And then also what’s ahead for stock as we move into ’23?
Joe Keating: Well, the strong gains in October, consider that the S&P 500 was up 8% that month, it has continued into November so far. We’ll see how things close today at a slower pace. And it’s really been a large-cap rally here during November as the small-cap stocks are actually slightly lower on the month. And stocks have weathered a very hawkish Chair Powell at the November one, two FOMC meeting, a meltdown in the cryptocurrency world. But they’ve been supported by the GOP narrowly taking back the house in the midterm elections, resulting in divided government with policy gridlock the likely outcome. And as we already talked about, investors cheered the CPI rising less than expected in October. That was really the push for higher stock prices during the month of October, an indication that while inflation is still a threat to the economy, pricing pressures look to be cooling.
Lastly, there’s a growing belief, pretty much a certainty I would say now that the Federal Reserve will step down at rate hikes at the December FOMC meeting. Positive seasonals are also likely at work as the October to April period traditionally is the strongest part of the year for stock gains. Additionally, the year after the midterms tends to see the highest equity returns of a president’s first four years in office, as divided government tends to make for more predictable politics. The S&P 500 has been higher one year after every midterm since World War II, according to the Stock Trader’s Almanac. However, while it is no exaggeration to say that the midterm elections are one of the best historic buy signals for stocks that exist, currently, any boost to investor sentiment could be limited as the Federal Reserve has been tightening policy, as we all know since March, and is expected to remain on its path of raising interest rates to bring inflation under control for a couple more months, at least, resulting in this flat-out stalling in the economy and corporate earnings probably coming under some level of pressure.
As we’ve stated many times, the path forward for common stocks hinges heavily upon inflation and how that influences the Federal Reserve’s policy trajectory. The two-month rally in stock prices, – now, when I say that, that’s assuming that we do see positive gains for the month of November – could go the way of the September rally if further evidence that inflation is cooling does not occur. So really nothing has changed for stocks. The key to the path forward remains inflation, which while remaining high, appears to have peaked and is trending lower. While near-term movements and markets are almost impossible to call, we look for stock prices to be higher a year from now as inflationary pressures ebb and the economy skirts a full-on recession. The reset in the markets as the Federal Reserve transitioned from a very easy monetary policy to an incrementally tougher inflation-fighting restrictive monetary policy stance has given investors an attractive entry point for both common stocks and fixed-income securities.
The primary risk to common stocks remains the outlook for earnings. Earnings have held up fairly well so far, despite the economy’s growth rate stalling. The analysts at Standard and Poor’s are now looking for operating earnings over the four quarters of 2022 to fall 3.2% compared to a 9% gain that they were expecting at the beginning of the year. Now, that would still represent a almost 65% gain from the end of 2020. Likewise, fourth-quarter operating earnings are now forecast to be lower by 4.3% year on year, but that would still be more than 42% above or ahead of the fourth quarter of 2020. The current earnings picture should continue into 2023 as the stalling economy has entered a disinflationary period. So that’s slowing, but still generally rising price level rather than a deflationary period, which would be a broad-based decline in prices.
The outlook for common stocks in 2023 will likely come down to a tradeoff between easing inflationary pressures, which will likely lead to easing financial conditions, and the outlook for earnings. Now, relative to is the bottom in, I think there’s a reasonable chance the October 12 low will hold. It really depends on this trade-off between inflation and earnings. And I think really it’s going to come down to how severely are earnings affected in 2023, or are they not affected to any great extent because as I said, we’re entering a disinflationary period as opposed to a deflationary period. So, reasonable chance the low is in but it’s a fool’s game to try to call bottoms or tops in the market.
Tom Fitzgerald: Well, I think all of our listeners hope you’re right, Joe, because we’re all sporting some pretty hefty, hefty losses from 2020 to 2022, so any gains will be greatly appreciated for next year. I can imagine I’m speaking for our studio audience on that as well. Joe, I just want to thank you once again for your thoughts today. Hopefully, we can reconvene in the first quarter of next year to kind of see how ’23 is getting started. And finally, just want to wish you and your family a very happy holiday if I don’t talk to you before then.
Joe Keating: Thanks, Tom, and same to you and your family. And as always, I’m just really honored to be part of these podcasts. So thank you, and everyone take care.
Tom Fitzgerald: Yep. Thank you, Joe.