Inflation, despite historically high deficits, stubbornly refuses to rise to the Fed’s relatively modest target of a mere 2%. In our last report, we noted that the Fed was finally ready to “stand pat” on further interest rate increases. We also addressed the importance of the yield curve in predicting future economic growth. At the time it was partially inverted (indicating an economic slowdown) due to the Fed’s aggressive interest rate increases last year. Since then, commodity and energy prices have modestly declined and labor costs have been rock steady. This week the Fed acknowledged that its interest rate target clearly overshot the economy and in Congressional testimony reported that it will reduce short-term interest rates this month.
The result of that pronouncement is that interest rates and the yield curve (still partially inverted) began to normalize with short-term rates dropping and long-term rates rising modestly. They both still have some distance to go to normalize but slow-growth anxiety appears to be diminishing. At present, the Fed’s posture is to closely watch the data and respond accordingly. However, there are complications. The interest rate reduction may give the appearance that the Fed caved to pressure from the administration. It didn’t, but that is beside the point as the President will undoubtedly believe and advertise that his pressure is working. The other wrinkle is that to fill Fed Board vacancies, he has nominated two people who seem to be slightly better suited than the two recently withdrawn nominees but who also appear to be equally ideologically driven (no surprise there) instead of data driven. Initial political temperature readings indicate that these nominations will likely succeed.
The economy has in fact slowed somewhat and still remains relatively strong but with a little breathing room. Inflation and labor costs remain very solid. However, the impact of the tax cut stimulus appears to be waning. Its intent was to stimulate capital investment, roughly one third of the economy. By essentially sidestepping consumer tax cuts, consumer spending which comprises roughly two thirds of the economy simply held steady. Incredibly, the tax cut proponents failed to recognize that investors and corporations generally do not invest in production equipment until they see an increase in demand for the products to be produced. This demand ultimately always originates with the consumer. Until consumers receive additional buying power in the form of tax cuts or other stimulus, aggregate demand and capital investment would seem to be maxed out for this cycle.
Since its creation, the Fed in efforts to tame a perceived overheating economy, has never achieved the proverbial economic “soft landing” without causing a recession. The economy, despite its momentum, does not appear to be overheating and the new reversal in interest rate policy is evidence of a Fed that is attuned to that data. We hope that this remains the case and gives new hope for a first-ever soft landing (no recession – stable growth). We remain cautious and vigilant. Although our cash positions increased last year, the market has firmed and stabilized. As a result we have put some of that cash back to work. Please also remember that because these quarterly thumbnail sketches are very brief, do not hesitate to call me if you wish to discuss your account or our outlook in greater detail.
Very Best Regards,
Joseph L. Toronto, CFA