“Victory is not clearly in hand,” said Federal Reserve Bank of Atlanta President Raphael Bostic on Thursday at New York University, about the Fed’s fight against inflation. And most of the members of the rate-setting Fed committee would agree: as Bostic put it, inflation is not “inexorably declining” to the Fed’s 2% objective.
Indeed, Friday’s producer price index data (PPI) showed wholesale prices rose more than expected in January, and core PPI (food, energy, and trade services excluded) jumped 0.6%, its largest one-month gain in a year.
That may not be surprising given that nearly three-quarters (70%) of the 100 CFOs surveyed by BDO last October said they would raise their prices again in 2024.
Recent data on goods and services prices, particularly services, buttresses the argument that the Fed can hold interest rates higher for longer — without harming the U.S. economy.
“This constellation of data suggests to me that the current stance of monetary policy … may not be as tight as we would have assumed given the low neutral-rate environment that existed before the pandemic,” Minnesota Fed President Neel Kashkari wrote on February 5.
But the markets are still acting like rate cuts are not far away. The S&P 500 is up more than 5% this year, and as of Friday morning Fed funds futures still showed a 38% probability of 50 basis points of Fed funds rate cuts by September 18.
The fixed income markets, in addition, have been “assuming [that] inflation was somewhat under control, and that the Fed easing should follow — not that the Fed easing could follow but that the Fed easing should follow,” said Arnim Holzer, global macro strategist at Easterly EAB Risk Solutions.
In addition, in the last few months, many economists and Federal Reserve governors have been predicting low economic growth for 2024. But projections for GDP in the first quarter are rising. Forecasters surveyed by the Philadelphia Fed raised their projection of the annual rate of growth this quarter to 2.1%, up from 0.8% in the previous survey, according to a February 9 release.
Holzer said it all amounts to a confusing set of signals for CFOs. But it’s not so important to figure out who is right — the markets or the Fed — as to recognize the disagreement. Disagreement and a falling stock market (due to dashed expectations for rate cuts) mean volatility, but equity market volatility is still low: the CBOE volatility index was at 14.5 on Friday and, as recently as January 24, was at 12.49.
Normalization Not Ensured
“The post-COVID environment differs from the pre-COVID environment, and I think it's an incredibly important point,” Holzer told CFO.
Looking at the trajectory of volatility and the equity markets in general over the last year, “one would assume that there's an all-clear signal and that there's a lot of competence and there's much less uncertainty than I think the bottom-up fundamentals would warrant,” said Holzer.
“As much as Fed funds futures and an equity strategist would love to say that the Fed’s not in the game [anymore] and that it's now all about earnings, and we can assume that the Fed is going to normalize policy” the truth is the job of fighting inflation is not yet done, said Holzer.
“Stocks have been priced to perfection; volatility has been priced to perfection. And when things get priced to perfection, there's not a lot of wiggle room for disappointment."
Arnim Holzer
Global macro strategist, Easterly EAB Risk Solutions
For CFOs, all this probably means they should give up the assumption that there will be several rate cuts this year that drop the Fed funds rate significantly.
“Volatility in the markets was really enjoying the idea that rates were coming down and that that support for equities would be more entrenched,” Holzer said.
Since that probably won’t be the case, as a CFO, “When I look at projects to finance when I look at my investment portfolio, when I look at decisions around a pension fund, I have to assume that the volatility or the beta of my stock, the volatility of the capital markets, should be higher,” Holzer said.
“Stocks have been priced to perfection; volatility has been priced to perfection. And when things get priced to perfection, there's not a lot of wiggle room for disappointment,” he said.
Due to recent improvements in productivity and the possible longer-lasting, positive effects of fiscal and monetary policy, as well as potential advances in artificial intelligence, another question arises: “Does a trend downward in inflation or its return to 2% necessitate a return to the level of interest rates the U.S. had pre-pandemic?” Holzer asked.
If the U.S. doesn’t have a recession and a slowing of economic activity, could interest rates “be run at a hotter level” and “savers might not have to be punished as powerfully?”