The Case For High(er) For Longer Is Still Intact

Raymond James

Economy & Policy

March 31, 2023

Chief Economist Eugenio J. Alemán discusses current economic conditions.

We know that the markets continue to second guess the Federal Reserve’s (Fed’s) commitment to staying high(er) for longer with respect to interest rates. In fact, markets continue to have the Fed decreasing the federal funds rate considerably, to 4.25%-4.5%, later this year. The assumption from markets is that since the U.S. economy is going to enter a recession, the Fed is going to have to cut interest rates to help bring the economy out of recession.

This would probably be a good expectation had inflation remained at or below the Fed’s target as was the case on previous occasions when the Fed actually started decreasing the federal funds rate at the first sign of trouble. But inflation, depending on whether you look at the CPI or the PCE price index, is still too high for the Fed to digest. In fact, year-over-year CPI inflation was 6.04% in February of this year. However, 12-month average CPI inflation, which is how inflation actually affects consumers’ purchasing power, was still 7.75% in February of this year. If you prefer to look at the PCE price index, the year-over-year PCE price index was at 5.00% in February of this year while the 12-month average PCE price index was at 6.08%. And adding monetary stimulus into an economy that is still experiencing very high inflation is not what the ‘doctor’ recommends in these cases because it risks inflation remaining higher than the Fed’s target and threatens a ‘de-anchoring’ of inflation expectations, especially long-term inflation expectations.

Since the U.S. economy is still growing above potential output today, Fed officials cannot be accused of presiding over a ‘stagflation’ period, at least not yet. That is, a period in which the economy grows below potential (i.e., stagnant), and inflation is very high. Today, the U.S. economy is still growing above potential and thus is still generating high inflation, consistent with an economy that is putting pressure on resources and pushing those resource prices higher.

But this environment will not last much longer as we are expecting a recession to start during the second half of the year. As the U.S. economy enters a recession, economic growth will fall below potential growth. This means that the Fed needs to bring inflation down fast toward its target or risk being accused of driving the U.S. economy into a stagflation period, something Fed officials don’t want to be accused of doing. Thus, there are plenty of incentives for the Fed to continue with its hawkish stance on interest rates.

However, here is where we, respectfully, disagree with Fed officials. We believe that there is no need to continue to increase interest rates further to achieve their inflation goal. We think that 5.00% for the terminal rate today, plus the tightening effects of the recent banking sector turmoil, will be enough to take the U.S. economy into below potential growth while at the same time bringing inflation down to the 2% target over the next several years.

We still have 25 basis points of rate hikes in our forecast today because the Fed’s dot-plot during the March Federal Open Market Committee meeting had the median expectation for the federal funds rate at 5.1%. However, we should see if the current issues with the banking sector change Fed officials’ estimates of what they need to do, if anything, going forward.

The Fed will have only one more monthly inflation number, for March 2023, when they are scheduled to meet for the May Federal Open Market Committee (FOMC) meeting. That is, it will not have much more information than what it has today. Thus, we believe that the decision will probably hinge on the evolution of the banking sector from now until May 3, 2023, which is when the next decision is going to be made.

We still believe that the Fed needs to take a step back and wait until all the tightening done over the last year has an effect on the U.S. economy and continue to buy time for all the fiscal expansion during the COVID-19 pandemic to flush out of the system. 

Economic and market conditions are subject to change. Opinions are those of Investment Strategy and not necessarily those of Raymond James and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur. Last performance may not be indicative of future results. Consumer Price Index is a measure of inflation compiled by the U.S. Bureau of Labor Statistics. Currencies investing is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising. Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample. Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior. The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100. Leading Economic Index: The Conference Board Leading Economic Index is an American economic leading indicator intended to forecast future economic activity. It is calculated by The Conference Board, a non- governmental organization, which determines the value of the index from the values of ten key variables Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, Certified Financial Planner™, CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements. Links are being provided for information purposes only. Raymond James is not affiliated with and does not endorse, authorize or sponsor any of the listed websites or their respective sponsors. Raymond James is not responsible for the content of any website or the collection or use of information regarding any website's users and/or members. GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren't part of this index. FHFA House Price Index: The FHFA House Price Index is the nation’s only collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities that extend back to the mid-1970s. Expectations Index: The Expectations Index is a component of the Consumer Confidence Index® (CCI), which is published each month by the Conference Board. The CCI reflects consumers' short-term—that is, six- month—outlook for, and sentiment about, the performance of the overall economy as it affects them. Present Situation Index: The Present Situation Index is an indicator of consumer sentiment about current business and job market conditions. Combined with the Expectations Index, the Present Situation Index makes up the monthly Consumer Confidence Index. Pending Home Sales Index: The Pending Home Sales Index (PHS), a leading indicator of housing activity, measures housing contract activity, and is based on signed real estate contracts for existing single-family homes, condos, and co-ops. Because a home goes under contract a month or two before it is sold, the Pending Home Sales Index generally leads Existing-Home Sales by a month or two.

DISCLOSURES

Import Price Index: The import price index measure price changes in goods or services purchased from abroad by U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP). ISM New Orders Index: ISM New Order Index shows the number of new orders from customers of manufacturing firms reported by survey respondents compared to the previous month. ISM Employment Index: The ISM Manufacturing Employment Index is a component of the Manufacturing Purchasing Managers Index and reflects employment changes from industrial companies. ISM Inventories Index: The ISM manufacturing index is a composite index that gives equal weighting to new orders, production, employment, supplier deliveries, and inventories. ISM Production Index: The ISM manufacturing index or PMI measures the change in production levels across the U.S. economy from month to month. ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers' Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.

Source: FactSet, data as of 12/29/2022