Making Sense of the Fed

Like it or not, the Federal Reserve's actions (and sometimes just words) hold tremendous sway over the stock market and the economy. Their influence over the markets birthed the saying, “Don’t fight the Fed.” Recently, they released a statement about what they believe to be the future of their monetary policy in support of their stated goals: maximum employment and price stability. This post will examine what it means to investors in the coming year.

Without getting into the specific mechanics, the Fed has various tools at its disposal for achieving its two objectives. Historically, it was as simple as the raising or lowering of interest rates to control the flow of money in the economy. Recently, they have gotten more creative to deal with the financial crisis in 2008 and the recent COVID crisis. To understand the balance they must strike, picture maximum employment and price stability (aka “subdued inflation”) on opposite sides of a seesaw. If the economy is booming, people are employed, but the risk exists that prices start to inflate faster than desired. The Fed would, in this scenario, turn down the thermostat, so to speak, to try to tame inflation without causing the economy to slip into recession. It is a very delicate balance in regular times. In the era of COVID, the stakes are higher, and the difficulty is magnified. By now, most people are aware that things are more expensive than they were two years ago before any of us knew what mRNA was. The chorus was growing louder, begging the Fed to take action to control this rampant inflation. The Fed’s stance was that this inflation was transitory due to disruptions in supply chains and other COVID-related factors. Now that the stage is set let’s discuss the pivot they made. In plain English, they said they would start picking up the pace on measures to slow this inflation. They removed the word “transitory” to describe inflation, but they still blame the aforementioned COVID-related factors.

Peering into our crystal ball, I want to share some indicators that can give us a clue about the upcoming year(s).

Inflation Expectations

The first is the market’s inflation expectation over the next five years. As you can see in the chart, the measure peaked at 3.17% (that’s annualized inflation) near the middle of November. It currently sits at 2.66%. The market is by no means a fortune teller, but it gives a clue of the prevailing expectations based on where significant money is positioned. The expectation of runaway inflation was cooling before the official Fed statement yesterday.

Economic Growth

Next up is the yield curve. This is often looked at as a barometer for growth expectations in the economy. Put simply, the higher the number, the more economic growth the market expects. As you can see, the current measure is the lowest in a year, but still above zero, which is a positive.

Using these two measures, we can deduce that the market is pricing in slower economic growth and more subdued inflation. This would look more like the economy we knew before COVID, which is where I believe the Fed ultimately wants to return. Now that I think about it, I think we all would embrace a return to a pre-COVID world.

Author: David Rath, CFA

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