Powell’s Pickle

June 23, 2022

In January 2013, I was in the market for a new car. With gas at the time above $4 per gallon, I opted for a Ford Fusion Hybrid. Of course, as soon as I made the purchase, gas prices dropped and remained low for the next nine years. Why share this anecdote other than to illustrate my poor ability to time the market? It’s because I liken my experience of driving a hybrid vehicle to the Federal Reserve’s attempt to tame inflation and engineer a soft landing for the economy. My Ford Fusion has this feature called a brake score. Every time I brake, I receive a score out of 100%. The better I brake, the higher the score. While it may seem gimmicky, the brake score does help increase fuel efficiency by incenting me to stop gradually instead of slamming on the brakes.

Pedal to the Metal

The Federal Reserve is trying to achieve a high brake score through its current monetary policy. The U.S. economy is the car. For nearly two years, the Fed had the “pedal to the metal” to keep the economy afloat in the face of a global pandemic. The Fed lowered interest rates to 0% and embarked on massive quantitative easing (bond buying). Arguably it worked as the economy rebounded and markets soared. However, the highest inflation in forty years has become a nasty side effect.

The Fed’s loose monetary policy throughout the pandemic is not entirely to blame for the high inflation. There was tremendous pent-up demand and simply not enough supply to meet the demand. Basic economics tells us that alone leads to higher prices. On top of that, add in persistent COVID-related supply chain issues and a supply-side shock from Russia’s invasion of Ukraine that affected oil and other commodity prices. The result is a rather sticky inflation which has put Jerome Powell and the Federal Reserve in quite a pickle.

Applying the Brakes

The Fed’s primary objective has been and always will be maintaining price stability. So, when inflation began to percolate in the second half of 2021, the Fed decided to taper its bond buying. However, that was merely easing off the gas pedal. Why did the Fed not start raising rates then? Perhaps because many, including the Fed, believed the uptick in inflation to be transitory, meaning it would subside naturally. When that proved not to be the case, and especially as oil and other commodity prices spiked following the Ukraine invasion, the Fed had no choice but to apply the brakes in earnest. Three rate hikes (0.25% in March, 0.50% in May, and a whopping 0.75% this past week) took the Fed Funds rate from 0.25% to 1.75% in short order. And with four more Fed meetings left this year, the Fed Funds rate will likely end the year above 3%.

A Soft Landing or a Recession?

The question is whether the Fed can successfully tame inflation and engineer a soft landing for the economy at the same time. Will the Fed achieve a high brake score? By waiting to raise rates, the Fed must now play catch-up, which is why it raised rates so aggressively at the last two meetings. Will these rate hikes and those yet to come gradually slow down the car, avoiding recession? Or will they stop the car too late or too abruptly, triggering a recession? It is the uncertainty in the Fed’s ability to achieve a high brake score that has stock and bond markets selling off.

What does this mean for investors? Likely more volatility in the months to come until the Fed nears the end of its tightening cycle, inflation starts to fall, or the economy appreciably slows down. The good news is that inflation is projected to fall below 3% by 2023. And while unemployment will likely increase in the short-term as the Fed applies the brakes, the jobless rate is not expected to spike as one would expect in a recession. Furthermore, GDP growth is forecasted to be positive over the next couple of years. So, if there is a recession, the recession may be shallow and short-lived.

chart showing fed rate expectations

*Source: Bloomberg, FactSet, Federal Reserve, J.P. Morgan Asset Management.

Future Benefits

Even though the forecasts for inflation, unemployment, and economic growth, as shown above, are promising, the stock market, on the other hand, has priced in a much gloomier scenario. If we avoid recession (a high brake score), stocks will likely respond positively. And even if a recession does happen (a lower brake score), stocks historically perform well during recessions, as the market already starts to price in the economic recovery. As for bonds, the sharp rise in interest rates, while quite painful, has pushed bond yields to 4-6%, which is more than double of just a few months ago. Higher yields are a good thing for bond investors going forward.

As an investor, the best course of action is to not sell into the panic. Even the soundest strategies are not immune to losses when stocks and bonds broadly decline. However, markets have always rebounded from adversity and rewarded those who remained in their seats. And while we all hope Chairman Powell gets out of his pickle and the Fed achieves that high brake score, by the time we know for sure, markets will already be back on the road.

*Source: Bloomberg, FactSet, Federal Reserve, J.P. Morgan Asset Management.

Market expectations are based off of the respective Federal Funds Futures contracts for December expiry. *Long-run projections are the rates of growth, unemployment and inflation to which a policymaker expects the economy to converge over the next five to six years in absence of further shocks and under appropriate monetary policy. Forecasts are not a reliable indicator of future performance. Forecasts, projections and other forward-looking statements are based upon current beliefs and expectations. They are for illustrative purposes only and serve as an indication of what may occur. Given the inherent uncertainties and risks associated with forecasts, projections or other forward-looking statements, actual events, results or performance may differ materially from those reflected or contemplated.

Guide to the Markets – U.S. Data are as of June 15, 2022.