Stocks, Rates, and the Fed’s Math Games

What Powell means when he says rates are “moderately restrictive.”

KEY TAKEAWAYS

• Stocks near all-time highs while Powell calls them expensive

• Powell says rates are still “moderately restrictive” at 4.25%

• Taylor Rule framework suggests rates are roughly neutral to restrictive

• Markets and betting odds expect more cuts this year

• Powell is cautious due to inflation risk

MY HOT TAKES

• Powell’s “expensive stocks” comment is Greenspan déjà vu–read Monday’s post if you missed it 😉

• The Taylor Rule is a math exercise that hides as much as it reveals

• Markets trust their gut more than Fed equations

• Powell’s fear of inflation is more about credibility than economics

• Volatility isn’t gone, it’s just waiting for the right excuse to show up

• You can quote me: “The Taylor Rule is math cosplay for central bankers.”

Rate my rate policy. Chairman Powell thinks that stocks are expensive. Under normal circumstances, and if he were not the Chairman of The Federal Reserve, I would respond with a “thanks for that blinding glimpse of reality.” But because stocks are right around all-time highs with an active Fed and earnings season a few weeks out, I would say that we are hardly in a normal circumstance. Stocks are clearly exposed to all manner of vagrancy with a particular sensitivity to interest rates.

You can shrug off interest rates–as I sometimes do–by reminding yourself that a 25 basis-point move in the overnight lending rate between banks shouldn’t make a difference in whether or not NVIDIA will continue to dominate AI or how many people line up for Eli Lilly’s GLP-1 drugs, but the fact of the matter is that interest rates are important. They obviously impact each sector differently–clearly some sectors are more reliant on institutional and retail financing than others. My two examples are not. 

Ok, so markets are very sensitive to Fed rate policy at the moment, and Powell said, “by many measures, for example, equity prices are gaily highly valued.” That is kind of equivalent to Alan Greenspan’s irrational exuberance speech, which I wrote about in Monday’s blogpost/newsletter. What he also said was that the Fed Funds Rate was “still moderately restrictive.” In other words, even with last year’s and last week’s cuts, the Fed Funds Rate at 4.25% is still keeping the economy from growing at its full potential. I often refer to this as driving with the parking brake partially engaged (pulled up or pushed down, depending on how old you are).

Let’s explore that for a moment: moderately restrictive. First of all, how does he know? When Powell stands at a podium and says something like that, he isn’t pulling that line from thin air–there are frameworks behind it. One that you might have heard of is the classic Taylor Rule, which ties policy rates to inflation and the output gap, with r*--the neutral real rate–as the anchor. Here is the equation for the Taylor Rule:

i = r^∗ + π + 0.5(π - π^∗) + 0.5(y - y^∗)

Where:

• i = policy rate
• r^∗ = the neutral real interest rate
• π = current inflation
• π^∗ = inflation target (2%)
• (y - y^∗) = output gap (how much actual GDP is above or below potential)

Even if you just glossed over that, you would notice that r^* is a critical input. I mean, who knows what that “neutral” real rate is where it neither helps nor hinders economic growth. The problem is that r* (pronounced r-star by nerd economists and Fed insiders 🤓) can’t be observed, so the Fed leans on tools like the Holston–Laubach–Williams (HLW) framework, a statistical filter that sifts through GDP, inflation, and interest rate data to tease out hidden trends. Wait… am I boring you with this? I notice a glossed-over look developing on your face. Let me make it simple: the Fed uses an equation that takes a bunch of actual and statistically projected inputs to determine where policy rates should be. If you walk away with that, you are highly informed, but I want you to know a bit more, so keep reading.

Plugging in today’s PCE inflation, a small positive output gap, and an r^* in the 0.5% to 1% range (that is estimated by the Congressional Budget Office), the Taylor Rule spits out a rate right around where the Fed Funds Rate sits today: roughly neutral, leaning slightly to restrictive. Now, of course, like all forecasting, the output changes based on the inputs you choose. For example, if we used headline PCE inflation versus Core PCE Inflation, the target rate gets lower. The Fed claims to focus on Core–which in of itself is a weird story for another blogpost–which would land the target rate above where rates are today. That means rates are not restrictive, but if we lower r^* to 0.5% we get a target of 4.1%, which means that rates are moderately restrictive–exactly what Powell said yesterday. If you chose to look at headline inflation–which I prefer because we still need to purchase gas and food (lol 🤣)--you get a target range below the current rate (3.65% - 4.15%). That means that rates are restrictive and could stand to come down by another 50 basis points or so. 

Does that sound familiar to you? It should, because that was the median FOMC forecast for year end. Now, I know that I am boring you with math, but I want you to know that it really is just math, silly. Math is great! I love it because it gives me comfort. I can hide behind the numbers and avoid any errant-laden gut feelings. I say that tongue-in-cheek because I know, like you know–in my gut–that rates are certainly restrictive for the real estate and consumer discretionary sectors. 

Powell? He knows it as well, so why is he so desperately trying to lower expectations of further rate cuts. Or better yet, why didn’t he vote along with neophyte FOMC Governor Miran to lower rates by 50 basis-points? Why would he want to keep rates restrictive when he has observed–not projected–weakening employment? Because he is worried about inflation–we are all worried about inflation. 

On Friday, we are going to get the latest BEA release of inflation. The PCE Price Index is expected to tick up to 2.7% from 2.6%. Looking back at our Taylor Rule equation we note that the target rate would tick up by 0.15, so the current Fed Funds rate would be less restrictive. If the number comes in at 2.8%, above estimates, the target range would be 3.95% to 4.45%, which is at the low end. Current rates would be considered less restrictive with the lower end of the range just 25 basis points lower than where the Fed is today. 

If we go with the FOMC’s median yearend PCE forecast of 3.0%, we get a target range of 4.25% to 4.75%. The low end of the range is the current target, and rate cuts would be inappropriate. The market clearly disagrees. Fed Funds give us a 100% of 1 more cut and a 75% chance of a second. According to Polymarket betting markets, there is a 64% chance of 3 cuts, a 21% chance of 2 cuts, and a 4.6% chance of only 1 cut.

Ok, so Powell thinks that stocks are expensive, but the market…well, it seems to disagree. Chairman Powell and the Taylor Rule think that rates can stand to be slightly lower. Technically, the median yearend inflation forecast of FOMC members put targets pretty much where we are today–no more cuts. Futures markets don’t agree, neither do the betting markets. If I were a betting man–and I am not–I would bet that I have properly confused, you this morning with silly math. That wasn’t my goal. My goal was to show you that there is some basis for what appear to be silly statements made by central bankers sometimes. Even though your gut–just like theirs tells you exactly what is going on today…no math needed.

YESTERDAY’S MARKETS

Stocks declined yesterday as Powell comments touched a raw nerve, saying that stocks are expensive and implying that 2 more rate cuts are not guaranteed. 😥 10-year yields ticked lower while gold and cryptos ticked higher.

NEXT UP

• New Home Sales (August) is expected to have slipped by -0.3% after falling by -0.6% in July.

• The Treasury will auction $70 billion 5-year Notes and observers are watching carefully to see if bond vigilantes get involved.

• San Francisco Fed President Mary Daly will speak today. She is a dove but doesn’t vote right now.

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