Fed Stands Pat, Pundits Speculate Further

If we had the misfortune of being the people who write about daily stock market movement, we would probably say something like this today: Stocks initially fell on news the Fed decided to pause its rate hikes Wednesday, but markets recovered to finish the day flattish as Fed head Jerome Powell and the Fed’s own forecasting materials made it clear the fight against inflation isn’t over. But thankfully, we don’t have that job, so we won’t try reading into the market’s 25-minute-long dip or the ensuing 40-minute bounce back. Nor will we square those zigs and zags with the precise moment it occurred during Powell’s press conference to see what could possibly have triggered traders. All of this is too subject to emotions and algorithms to draw meaningful conclusions from. Yet we do have some beef with the popular view that the Fed must do more to tame inflation—and that doing more necessitates falling stocks.

One popular viewpoint entering Wednesday’s meeting was that if the Fed’s work were finished, we would see it in sluggish or falling GDP, a sinking stock market and higher long-term interest rates. Therefore, the decision to pause and keep the fed-funds target range at 5.0% – 5.25% means the Fed will probably have to hike more later to make up for a premature victory declaration, setting up more trouble for markets down the road. We beg to differ. There is no preset relationship between short-term interest rates and economic growth, nor between economic growth and inflation, so GDP is a poor thing to use as a report card. As for stocks, they have a long history of rising during rate hike cycles. Last year, it seems to us the Fed’s huge inflation U-turn caught many investors—who took officials’ words and projections too seriously—off guard, with the surprise contributing to the cavalcade of worries that drove the downturn. But the Fed continued those hikes for seven months after stocks’ latest low. That looks to us like markets got over the twist, priced in the Fed’s actions and moved on. Lastly, for rates, last we checked long rates move primarily on inflation expectations, so 10-year US Treasury yields’ downward trip since last October would imply markets simply see lower inflation ahead, which looks pretty sensible given economic trends and input prices.

Might we offer another way to look at all of this? The primary way the Fed would affect the economy is through lending. The fed-funds rate influences banks’ funding costs, and banks’ business model is to borrow at short rates, lend at long rates and profit off the spread between them. If bank funding is expensive and loan rates aren’t high enough to justify the risk of new lending, then credit dries up, the economy gets less fuel and growth slows or contracts. So “tight” Fed policy would be evident first in weak lending, which we would define as loan growth slipping below the core inflation rate. As it happens, that was the case throughout most of 2021 and into early 2022, tied largely to the reversal of pandemic-era emergency lending. Loan growth didn’t start topping the core inflation rate until after the Fed started hiking last spring, and it accelerated through yearend. It didn’t start slipping back toward the core inflation rate until March’s regional banking tremors. Perversely, you could argue money was tight before the Fed started hiking, loose while they were actually hiking, and is now inching toward tight-ish. Given monetary policy hits the real economy at a significant lag, if you think rate hikes are behind the slowdown, it seems sensible enough for the Fed to wait and see if it slows further, lest they overshoot.

With that said, we don’t think rate hikes deserve credit for the lending slowdown. Overall and on average, banks still aren’t passing rate hikes to depositors. Yes, some savers have ditched their favorite megabank for a money market fund or online savings account, where rates can be closer to the fed-funds target. But the national average deposit rate was just 0.39% in May, the latest figure available.^[i] Deposits, though down from early-2022 highs, remain far above pre-pandemic levels. So it doesn’t look like banks’ low-cost funding base is eroding fast. Rather, the lending slowdown seems more like a function of a high base effect from 2022 and banks taking a wait-and-see approach during the regional banking dust-up. With the dust there settling, it wouldn’t surprise us to see lending remain resilient.  

Mind you, our analysis operates on a pretty specific, Milton Friedman-ish view of how monetary policy and the economy intersect. This thinking has gone out of fashion with most Fed folks, who seem to focus more on labor markets and wages, despite the Fed’s own research from last month showing those have a minimal impact on future prices. At his post-meeting press conference today, Powell flagged “loosening of labor-market conditions” as something the Fed needs to see continue before they can be confident inflation will slow back to their 2% year-over-year target. So we don’t think it is wise to try to predict the Fed’s next move based on loan growth trends.

But we also don’t think it is wise to use the infamous “dot plot” of Fed forecasts, which also came out Wednesday, as a prediction tool. Doing so largely overlooks the evidence from just last year that you can’t take it to the bank. Yet that is what the world did Wednesday afternoon, noting the forecast points to two more rate hikes this year and four rate cuts in 2024, presuming the Fed moves in single 0.25 percentage point increments. Please, dear readers, don’t get sucked into this. One, these dot plots are always in flux. March’s version showed the median forecast was for the fed-funds range midpoint to finish 2023 at 5.1%, which is basically where it is now. The update bumps the median forecast to 5.6%. It moved! And a moving target is useless. Two, focusing on the median ignores that the dot plot contains 18 individuals’ forecasts, and those 18 run the gamut. Three, even if the median forecasts prove correct, it is impossible to know how the Fed would get there. What if it indeed hiked twice more this year … and then cranked rates up to 7.5% – 7.75% by next May before cutting steeply to 4.5% – 4.75% by yearend 2024? That would fulfill the median forecast, technically, but it could be a surprise.

Rather than try to predict the Fed, which we think is impossible, we suggest simply waiting, seeing what they do, and assessing the pros and cons of each decision as it happens. With loan growth and inflation slowing, a pause seems fine to us. Not necessary, as there is no indication a couple more hikes would tip the scales, but fine.