What the Fed Said

Sometimes the Federal Reserve speaks in riddles and leaves plenty of wiggle room for forthcoming policy. However, Wednesday the communication was clear; or was it? To recap, the Fed said that the ultimate destination for the Fed funds rate is much higher. They did acknowledge that they would soon get to a point where increases are likely to be less than the ¾% that has been the recent pattern. That would allow for the economy to gradually catch up to the effects of interest rate hikes already made. (Remember, monetary policy works with lags of up to one year.) The Fed also made clear that they are willing to create a recession if that is what is needed to break inflation.

How do we as investors interpret all of this? We may ultimately see short-term rates approaching 5%. The next few rate increases may be in smaller increments than the recent ones. One half percent is likely in December. One quarter percent moves, perhaps, after that. A recession is increasingly likely next year. We have already entered one with an inventory correction, but this will continue to roll through the economy until every sector is affected. Unemployment will eventually increase, and inflation will gradually decline to the 3 – 4% range. Longer term interest rates may not go much higher because investors recognize that with lower inflation coming, they are already approaching fair value. Once we are in a recession and inflation retreats, the Federal Reserve will need to lower short-term rates. Long-term ones will probably not budge.

So, if the economy is likely to get worse, what does that mean for the stock market? Perhaps not too much. Investors have already been adjusting to the new realities. They have done this while the current economy is still good. They will soon have to anticipate the Federal Reserve’s success and eventual economic recovery. This is a clear example of how the stock market cycle and economic cycle are not synchronized. The stock market is way ahead of the economy. None of what we as investors have been going through is any fun. However, better days are coming. Stay steady my friends.

The Lonely Bull