Inflation Leaves The Fed With No Good Choices

Last week’s consumer inflation (CPI) reading at 7.9% year-over-year was at a forty-year high as expected. This February reading only reflects some of the impacts of rising commodity prices from the Russian invasion of Ukraine on February 24 and the resultant sanctions. In addition, the Atlanta Fed’s measure of “sticky” inflation reached its highest level since the early 1990s.

The “sticky” inflation can be seen in the two measures of rent used in the calculation of CPI. The rent components were 4.3% and 4.2% higher year-over-year in February. Rents do not tend to fall except during extreme situations like the Global Financial Crisis, so it raises the specter that inflation may remain elevated.

Rising commodity prices have helped trigger a recession in many periods historically. While prices have risen sharply since early 2020, the inflation-adjusted price remains relatively low. However, the recent move has seen commodity prices accelerate well above the pace of overall consumer inflation.

With the backdrop of rising price pressures, the Federal Reserve has no choice but to begin the tightening cycle at the meeting this week. In the recent past, the Fed had the option to delay raising rates if the economy was starting to soften or if there were external uncertainties, like the war in Ukraine, but that option is not available now. The good news for this week is that this is perhaps the most expected hike of 0.25% in short-term interest rates in history, with Chair Powell taking the very unusual step of pre-announcing his vote to raise rates. This move by Powell should limit some of the volatility surrounding the announcement, but the Fed will also release new quarterly forecasts, which could have some impact. The market is currently expecting this to be only the start of the hikes, with almost eight 0.25% increases priced into the market over the next 18 months.

As discussed last week, the yield curve has the most accurate predictor of recession. Historically, when the yield on the U.S. 10-year Treasury falls below the 2-year yield, also called yield curve inverting, a recession is coming. The yield curve has still not inverted and held steady last week, but the differential has shrunk markedly since the start of 2022.

With the Federal Reserve forced to raise short-term interest rates due to rising inflation, the odds that our central bank could be forced to break inflation and unintentionally break the economy are indeed rising. A recession has followed nine times in the last thirteen Fed tightening cycles. Stocks have tended to decline during the three months after the first rate hike, with a median decline of 2.7% but more than recover six months later. Since this hike was so telegraphed relative to the norm, this decline may have already begun.

Historically, stocks have risen 85% of the time during tightening cycles despite the many recessions following these periods. There remains a bit of a warning in the data, though. Periods of stagflation like the 1970s, which is high inflation combined with poor economic growth, have not been kind to stocks or most other assets. The S&P 500 declined from 1972 to 1974, but the period from 1976 to 1981 was ugly as well despite the positive return. The CPI rose at an annualized pace of over 10% during this period, while the S&P 500 increased by an annualized 5.8% rate. To be clear, the U.S. is not currently experiencing stagflation, nor are we destined for a recession in the short term, but these fears are weighing on the market.

The uncertainty surrounding the threat of stagflation, recession, and geopolitical events seems likely to keep market volatility elevated. Stocks have typically risen even after the yield curve inverts and signals a future economic downturn. Stocks have also risen during most Fed tightening cycles but struggle in the period immediately following the first rate hike. Stock declines associated with geopolitical fears have generally been a temporary setback, but the timing of the rebound is always unclear. Investors should retain enough lower-risk assets like cash and high-quality bonds to support living expenses during any unexpected economic decline but look for market opportunities during this market correction. As noted in a previous piece, a focus on quality companies and dividend payers is likely a good strategy now while keeping a keen eye on the ability of the company to pass along price increases in this inflationary environment.

Source: Forbes