Lower is the New Higher

A funny thing happened on the way to lower rates… Fed projections went up, not down. Wall Street was focused on the Fed’s median for 2024 projection, which was unchanged at three 0.25% rate cuts this year. But the economic gurus at the Fed took away one rate cut in 2025 and one in 2026. Did Wall Street panic? Not a chance. The Street simply converted the fear of ‘higher for longer’ and exchanged it for promise of “lower, but slower’. Wall Street has a special way of accentuating the positive and that pushed stocks further into overbought territory and actually pushed the 10 year Treasury Yield a bit lower (i.e., price higher).

FOMC Dot Plot

It seems like forever ago we first discussed the Fed having to thread a needle in order to produce the desired soft economic landing. We sit here today telling the same story. The needle hole looks a bit bigger now, and therefore easier to accomplish, but the goal is the same – avoid a recession. However, it is getting a bit more confusing to keep score. If you’re bullish, what do you want to see from here? Ideally, you’d like to see economic growth slow down a bit, allowing the Fed to gradually reduce interest rates, which would lead to more robust growth, and presumably higher stock prices, down the road.

What you don’t want to see is a sudden drop in economic activity. Because of the lagged effect of monetary policy on the economy, a sudden drop would imply that rates were kept too high for too long, and that would raise the risk of a recession all over again. On a positive note, that would certainly kill the inflation dragon, but it wouldn’t be much fun for the stock market.

By the same token, you don’t want economic activity to be too strong either. Inflation is already showing some early signs of stickiness at 3%. If the economy doesn’t slow down, the risk of inflation re-accelerating comes into play. We recall from the last great inflation episode in the 70’s-80’s that inflation came in waves (see chart below). Each time it appeared the inflation genie was headed back into the bottle, it came roaring back. This is why the Fed appears so adamant that they must be convinced inflation is ‘sustainably’ under control before they cut rates.

If economic activity were to reach ‘escape velocity’ for inflation, it would force the Fed to stomp on the economic brakes very hard to avoid a repeat of this trend, and much like Paul Volker in 1982, a recession would likely ensue. The bottom line is that things look better now than they did last year, but the job is not yet complete.

What Are We Watching?

Our primary concern is the labor market, which has been pumping out mixed signals for some time now. The current consensus is that the labor market remains tight and it is hard to envision a recession with very low unemployment – when people work, they spend. The problem is that the Household Survey and the Establishment Survey, both produced by the Bureau of Labor Statistics, are singing different tunes. The Fed appears to prefer the Establishment survey, which suggests a strong labor market. We want to stay keenly aware of the Household survey and other labor indicators (small business hiring plans, average hours worked) that are beginning to show some cracks in the labor market. A little weakness in the labor market is not a bad thing right now. It would reinforce the Fed’s confidence that it can begin to cut rates later this year. However, a lot of weakness would be a problem.

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By: thinkhouse