Inflated

Inflated.  Stocks rose yesterday after the FDA approved a low-cost device for COVID rapid tests.  The Fed Chief signaled a looser policy going forward, further stoking the equity rally in yesterday’s session.

N O T E W O R T H Y

Easy living.  The Fed has a simple but difficult mandate. Simple on paper, that is.  The Fed’s longstanding mandate was to control inflation.  In the 1970’s, inflation was public enemy number 1 as rising fuel costs sent shock waves through the US economy.  It was during that period that the central bank really began to take front and center on the economic and financial markets stage. Rising inflation that comes from an overheating economy ultimately leads to disaster as the dollar loses its power to power consumption… which makes up roughly 70% of economic growth (I know I keep reminding you about this, but it is important).  If a $1 dollar loaf of bread doubles in price to $2, a consumer’s greenbacks are worth 50% less.  Assuming that wages stay the same, consumers are stuck as they can now only afford to buy 1/2 a loaf of bread.  For producers, on the other hand, inflation is good as it allows them to raise their prices.  Of course, the caveat is that when prices get too high, consumers simply will buy less.  So, there is a tricky balance between good inflation and bad inflation.  Put more simply, a little inflation is OK but too much is bad.  Striking that balance is the historical job of the Fed.  Back in the 1970’s the Fed adopted a theory based on the Phillips Curve, which showed the positive relationship between employment and inflation.  If more people have jobs there is more consumption.  Increased demand from the rise in consumption leads to higher prices, AKA inflation.  So goes the theory, which makes sense.  I should say: "made sense".  The adoption of the theory meant that the Fed took on what is now referred to as a dual mandate, which implies that they are responsible for keeping employment healthy while maintaining low inflation. The Phillips Curve suggests that you can’t have both, which makes the Fed’s job tricky.  If unemployment gets really low, the economy heats up and Fed raises interest rates to pump the brakes before inflation gets out of control.  There was a lot of tweaking along the way, but there have been roughly 6 rate increase regimes since 1970… all of which preceded a recession.  There are many other factors that lead to a recession but high interest rates are certainly a key, if not the key factor.  As you are probably well aware, nothing is simple when it comes to the economy and the markets.  After the Great Recession and Global Financial Crisis, something changed. Unemployment, which spiked to 10% immediately after the recession ended in 2009, slowly recovered, finally attaining its pre-recession level in late 2015.  What is interesting is that unemployment continued to fall, hitting 60 year lows by 2019.  If we refer back to the Phillips Curve theory, we can assume that inflation must have been rampant… which it wasn’t, even as interest rates hovered just above zero for many years after the recession.  This, as you might guess, confounded economists and central bankers.  Having set a 2% target for inflation back in the 1970’s usually meant that the Fed would have to raise rates to bring inflation down if it exceeded the limit.  In contrast, over the past few years, the Fed has been trying to ignite inflation to rise to their target.  Remember, some inflation is healthy.  So, the past few years have shown that you can have both.  The Fed has been grumbling about introducing some policy changes for some time.  With monetary policy extremely loose, the Fed is looking for more ways to stimulate the economy as it heals from the devastating shock brought on by the COVID pandemic.  Yesterday, in his speech at the Jackson Hole policy symposium, Fed Chairman Jerome Powell outlined the basis for a massive change in policy. The Fed will now target an average inflation of 2%, leaving behind an absolute target level. You are probably thinking “that doesn’t seem like such a big deal, Mark”.  If you consider that inflation has been very low recently, the Fed would have to let inflation go quite a bit higher than 2% in order to get the average to hit the 2% target.  What it really boils down to is that the Fed is going to intentionally let inflation heat up.  That means low interest rates for longer.

THE MARKETS

Stocks rose yesterday on news that a low-cost, rapid COVID test got the thumbs up from the FDA while the Fed signaled softer policy for longer.  The S&P500 rose by +0.17%, the Dow Jones Industrial Average climbed by +0.57%, the Russell 2000 Index advanced by +0.28%, and the Nasdaq Composite Index slipped by -0.34%.  Bonds slipped and 10-year treasury yields added +7 basis points to 0.75%, largely in response to Powell’s hinting that inflation will be allowed to exceed the old limits.

NXT UP

- Personal Income (July) may have fallen by -0.2% compared to the prior month’s -1.1% drop.

- Personal Spending (July) is expected to have grown by +1.6%, down from June’s +5.6% growth.

- The PCE Core Deflator (July) is expected to be 1.2% year over year.  That is well below the Fed’s now-tweaked 2% average target.

- University of Michigan Sentiment (Aug) is expected to be 72.8, in line with earlier estimates.

- Next week we will get PMIs, Factory Orders, The Fed’s Beige Book, and most importantly, the monthly employment numbers. Check back on Monday for calendars and details.

daily chartbook 2020-08-28