The Fed Scenario That Could Catch Investors Off Guard [Dow Jones Industrial Average, Vanguard Total Stock Market ETF]

Janet-YellenChris Ciovacco: In order to understand the debate that is likely to take place within the Fed this week, it is important to understand what a “perfect world” interest rate cycle looks like from the Fed’s perspective:

  1. The Fed lowers rates to combat slowing growth, a recession, or crisis.
  2. The economy responds favorably.
  3. Inflation begins to pick up as pricing power returns.
  4. The economy is strong enough to allow the Fed to gradually raise interest rates to slow inflation without harming the improving economic climate.

Difficult Challenge To Balance Growth And Inflation

In the present day, the Fed has a problem with point 4 above. The economy is still relatively fragile, but inflation is picking up. From USA Today:

Consumer prices last month posted their sharpest increase in 15 months as inflation continued a recent acceleration from unusually low levels. The consumer price index jumped 0.4% after rising 0.3% in April, the Labor Department said Tuesday. Economists had expected a 0.2% increase. Over the past 12 months, consumer prices have increased 2.1%. “The chances that (the Fed) will raise interest rates before the middle of next year are increasing,” economist Paul Dales of Capital Economics said in a research note Tuesday.

Fed Expected To Lower Growth Projections

The Fed prefers to tighten policy when inflation and economic growth are picking up simultaneously, which is not what we have now. From USA Today:

The Federal Reserve is expected to lower its economic growth forecast this week, but falling unemployment and rising inflation could prompt policymakers to project a slightly more rapid rise in interest rates.

2009: An Extreme Case To Study

Since the market, rather than the Fed, ultimately sets interest rates, the Fed closely monitors market expectations for the economy and inflation. While beyond the scope of this article, in extreme terms maximum economic pessimism tends to be a “fear of deflation” state. On the other end of the confidence spectrum, when investors are confident about stronger economic growth, their expectations for future inflation tend to increase. While it looks a bit noisy, the chart below illustrates the concepts. The upper portion of the chart tracks inflation expectations. If investors are concerned about inflation they prefer to own inflation-protected bonds (TIP). When investors are concerned about a slowing economy and/or disinflation, they are comfortable with standard treasuries (IEF). In 2008 fear of deflation was increasing and stocks got hammered (left side of chart below). The right side of the chart shows as expectations for inflation began to pick up, the stock market eventually followed.

2009: Growth Expectations Were Picking Up

As noted earlier, the Fed prefers to see inflation expectations and economic expectations pick up simultaneously.

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