On the Viral ‘Split Fed’ Speculation

Mark your calendars, folks: August CPI comes out Wednesday, launching the final week of will-they-or-won’t-they speculation ahead of next week’s Fed meeting. If the latest commentary is any indication, it will be a doozy: According to a Wall Street Journal piece that went viral, the Fed is reportedly split in two camps, with half open to another rate hike and half favoring a wait-and-see pause. Some in the place formerly known as the Twitterverse think the Fed itself leaked news of this split to the Journal to prepare the masses for the tightening campaign to end before inflation returns to the Fed’s squishy 2.0% year-over-year target.^[i] We suggest investors tune down this chatter, as stocks moved on from rates and prices long ago.

If the talk is to be believed, we might have zero hikes left. Or one. Or two. Or something-ish. Who knows! It all depends on the data, as well as how all members of the Federal Open Market Committee interpret said data through the lenses of their various philosophies, biases and reports from market participants in their districts. This last sentence encompasses dozens of unknowns, and that would be true even if the Fed weren’t reportedly split on the matter.

Yet here is something we do know: We are now 11 hikes into this tightening cycle. This young bull market began between hikes five and six. If stocks have thus risen through 6 hikes in 11 months, where is the evidence that bumping it to 7 in 12 or 13 would be such a big darned deal? Especially when some of the previous six were very large hikes of 0.5 or even 0.75 percentage point. We have 11 months of stocks telling us they are over rate hikes.

As for inflation, we find it all a bit silly to say prices hinge on what the Fed does from here. Friends, the Fed just isn’t capable of fine-tuning the economy. It can’t pull a lever here and twist a dial there to get money supply growing at some magically perfect rate that gets prices and economic growth just-so. If it could, we wouldn’t have had last year’s inflation spike in the first place. In at least one way, rate hikes are actually contributing to the inflation problem at this point, because they are pushing up house prices, which feeds into CPI via owner’s equivalent rent. As we detailed earlier this summer, high mortgage rates have deterred sellers, reducing home supply—and lifting prices even as high rates make buyers skittish. Shelter is a large component of CPI and the main thing propping it up now. With it, core inflation (ex. food and energy) is running at annualized rates of 3.1% and 4.1% over the last three and six months, respectively.^[ii] But without shelter, those figures drop to 1.1% and 2.3%.^[iii] As Exhibit 1 shows, this is back to benign pre-pandemic rates. As is headline CPI, come to think of it, thanks to energy’s offsetting shelter. (Exhibit 2)

Exhibit 1: Services Aside, Core Inflation Is Back to Normal

Source: FactSet, as of 9/11/2023. Three- and Six-month annualized inflation rates, CPI ex. food, energy and shelter, June 2018 – July 2023.

Exhibit 2: So Is Headline Inflation

Source: FactSet, as of 9/11/2023. Three- and Six-month annualized CPI inflation rates, June 2018 – July 2023.

So we are hard pressed to see what another rate hike or two would accomplish. M4 money supply, the broadest measure, has contracted on a year-over-year basis since December. Considering inflation is always and everywhere a monetary phenomenon of too much money chasing too few goods and services, falling money supply means conditions are now inherently deflationary. And that is happening despite loan growth continuing to top inflation rates, which is in turn happening despite Fed rate hikes. Seems to us the Fed is getting what it wants despite its tools not working as intended.

Markets are well aware of this even if people aren’t. Stocks have a long history of seeing through things the world obsesses over while quietly weighing overlooked factors. They see the various surprises and seeming contradictions in how the economy has evolved alongside rate hikes. Seems to us they figured out that the economy would be fine despite the Fed long before all of the recent “soft landing” chatter materialized. If they figured this out several hikes ago, we doubt they hinge now on whether the Fed pauses.