The economy might need a new antibiotic

Core PCE, the Federal Reserve’s preferred measure of inflation, is still close to three percent as of the end of April 2023, well above the FED’s target of two percent. Yet, looking at 30-day FED funds futures, market participants are pricing in a 75-percent chance of two rate cuts by December 2024. 

With FED commentary regarding rates continuing to message “higher for longer” or “higher for an indefinite amount of time,” there seems to be a bit of a disconnect between the central bank’s message and private sector projections. 

So what’s going on here, exactly?

The effect of the stimulus could be waning

Interest rates only tell part of the story. For a fuller picture of monetary policy, we also must look at M2 money supply. This is the measure of U.S. money stock: all currency held by the non-bank public, plus savings accounts, certificates-of-deposit under $100,000, and shares in retail money market funds. 

Increasing money supply is the other, less discussed, lever the FED can pull when it needs to provide stability to the economy. 

To combat the economic turmoil caused by the COVID pandemic, the Federal Reserve pumped about $5 trillion of new money into the economy to support fiscal spending via stimulus, PPP loans, student loan delays/cancellations, etc. 

What our friends at First Trust have postulated is that so much money was added to the economy, in a short amount of time, that it was not absorbed all at once, and that it would take time to work its way throughout the economy. 

Now we’re seeing evidence that excess money supply has made it all the way through via struggling lower-end consumers. This point-of-view is also voiced by a few of our asset managers, that the current economic environment is good, but perhaps not as great as implied by the headline numbers. 

The general idea is that as consumers spend less, inflation should fall in kind. 

Maybe interest rates can only do so much

Rick Rieder, CIO of Global Fixed Income at BlackRock, Inc., provides a refreshing take on the current situation and disconnect in that a higher FED interest rate is inflationary and the FED needs to cut to bring PCE down further.

To summarize, he believes interest rates, as a monetary policy tool, have changed dramatically as the U.S. economy transitions to one that is more service-based, as well as a number of other secular changes.

Higher interest rates have greatly impacted interest rate sensitive areas of the economy, such as housing, small business, and bank-based lending, and there is not much the FED can do about higher auto-insurance rates.

Our interpretation is that increases to the FED target rate might be comparable to the efficacy of antibiotics, where the effects wear off over time.  

In many respects, there is not a disconnect between FED futures and FED commentary, as it is reflective of a well-functioning market. Market participants are merely placing bets that inflation will drop much quicker than anticipated for the reasons previously outlined. 

At EdgeRock, we don’t know if and when inflation will fall further toward the FED’s target of two percent. However, our experience tells us that meaningfully diversified allocations, customized for individual financial plans should still be appropriate for market conditions at this time.