Financial markets have settled down a bit, with near-term interest rates anticipating a quick end to the Fed’s monetary restraint. Although the forecast implied in low interest rates is encouraging, it also appears unrealistic.
The Week That Was
There was little significant news on the economy last week. Economic data continue to point to a strong first quarter, with a real annual growth rate close to 3 percent.
Chairman Jerome Powell’s press conference on Wednesday provided several interesting insights in response to some excellent questions from reporters.
First, Powell stated the Fed would no longer state its intent or bias with respect to further increases in the fed funds rate. One reason for removing this was the belief that a tightening in credit conditions following bank failures could be an additional factor in containing both credit and inflation.
Despite removing the bias toward further rate hikes, the Fed’s forward looking policy projections have a fed funds range of 5.1 percent to 5.6 percent for this year, and 5.1 percent to 5.4 percent in December.
When asked about the interest rate cuts implied in current yield curves, Powell said interest rate cuts are not part of the Fed’s deliberations. With both the economy and inflation coming in higher than the Fed expected, containing inflation remained the main objective.
When asked about the potential conflict between reducing the Fed’s balance sheet and loaning money to risky banks, Powell said the two were not inconsistent. Powell said loans to banks have a different impact on money than purchases (or sales) of securities. This was a point I made during the financial crisis of 2008. I agree with the Fed chairman on that.
Things to Come
The most significant economic news this coming week will be Friday’s report on February consumer spending and incomes.
February retail sales were up at an 8 percent annual rate from the fourth quarter. February employment and hours worked were up at annualized rates of 2½ percent to 3 percent, respectively. These numbers point to fairly strong first-quarter growth.
Look for Friday’s spending and income report to show the first quarter real growth rate was 2 percent or more. With February inflation at 4 percent to 5 percent, our estimate for first quarter current dollar GDP growth is 6 percent to 7 percent. If that is correct, it means there still are no signs spending is slowing as needed to contain inflation.
Despite these current trends, we continue to expect spending to slow in the months ahead. Without meaningful signs of slowdown this spring, the Fed will raise the fed funds rate another 25 basis points at its May meeting.
Money, Money, Money
Fed data show the central bank sold $538 billion in securities in the nine months ending March 22, 2023. Over the same period, banks have shifted $534 billion from their deposits at the Fed into the economy. The net effect has been nine months with virtually no change in the amount of money in the economy.
The main question is whether the shift from massive money supply increases is sufficient to slow the economy and eventually bring down inflation.
While we believe this will happen, there are signs indicating an overall slowdown has begun. Some view the Fed’s new Bank Term Funding Program (BTFP) to extend credit to eligible banks as an increase in money into the economy. I disagree. In the financial crisis of 2008, I indicated that TARP loans to banks did not increase the money supply and would not stimulate the economy. The same is true for the new BTFP program. The impact of temporary loans is very different from outright purchases (or sales) of securities.
Stock prices moved slightly higher this week, with the S&P500 holding slightly above its key 200-day average.
As expected, the Fed raised its target fed funds range to 4¾ percent to 5 percent. Chairman Powell also reiterated the Fed’s commitment to do whatever is necessary to contain inflation.
When asked about the implications for a cut in the fed funds implied in the one-year T-bill rate of 4.3 percent, Powell said cuts in interest rates are not part of their deliberations.
The major positive for stocks is the sharp decline in interest rates. Financial markets are anticipating a major weakness in the economy, relief on inflation, and the Fed cutting interest rates.
Neither we nor the Fed expect inflation to decline quickly enough to allow the Fed to cut interest rates.
For the moment, the shock to the banking system from the failure of three banks has subsided. However, criticism of the Fed’s oversight of Silicon Valley Bank will lead regulators to be more forceful in demanding more control over bank loans and investment portfolios. Some estimates indicate that increased regulatory scrutiny would be the equivalent of an additional percentage point increase in interest rates.
We continue to believe the overall banking system is healthy. However, the increase in regulatory burden on banks is likely to lead to further negative surprises. We believe that after nine months of monetary restraint, the worst is yet to come. We doubt interest rates will remain low without convincing signs of progress on inflation.
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Economic Fundamentals: negative
Stock Valuation: S&P 500 overvalued by 13 percent
Monetary Policy: restrictive