Time for the Fed to Claim ‘Mission Accomplished’

WISDOMTREE- Weekly commentary from Professor Jeremy J. Siegel (12/19/2022) :

It was a big week for the markets with the inflation report and the Fed decision. I remain upset at the Federal Reserve and messaging around its inflation fight. I believe it is time for the Fed to rightfully claim ‘mission accomplished’ and pause their rate hikes. But rather we keep hearing from Powell & Co that rate hikes are not yet sufficiently restrictive.

As I expected, the headlines read out a hawkish Dot Plot with 17 of 19 Federal Open Market Committee (FOMC) members penciling in rates staying elevated and above 5% by the end of 2023. Frankly, these dots are not worth the paper they are written on. Recall exactly one year ago when the FOMC put out their 2022 dots, all but 2 thought rates would not go above 1% by year end and the two most hawkish thought we’d get to 1-1.25%.

A year ago, I was saying we could get to 3% and people thought I was crazy. The Fed is making the same mistake in the other direction. Now I think rates will head down much sooner than the Fed currently indicates.

I have been adamant lagged housing data is distorting the official Consumer Price Index (CPI) releases. From March 2020 to March 2022, the Case Shiller Housing indexes went up 45.5%, yet the Bureau of Labor Statistics (BLS) housing inflation was up just 11%. Zillow Rentals for apartments showed 35-40% and again BLS statistics indicated about 10%.

Powell acknowledged this discrepancy in real time leases at the latest press conference, yet strangely his comments indicate needing to wait for 6 months when the CPI’s backwards looking official statistics catchup with what is happening in the real world today! CPI calculations way understated inflation in 2021 when real inflation was likely in double digits and now we are way over stating inflation. Relying on this lagged data is a very poor way to set monetary policy.

All other sensitive inflation indicators have turned down and no longer look like a major threat to current inflation. Commodity prices have turned down. Shipping costs and freight rates have turned down. All good markets have really turned down. China is starting to open should also help with supply chain issues and further bring down some inflation pressures, even though it might support commodity prices next year.

Currently there is a sharp inversion in the yield curve and a dynamic with the 2-year yield now being below the new Federal Funds target range. The market appears to agree with my assessment and does not believe Powell will keep rates elevated. This strong inversion across the entire yield curve has been an excellent predictor of recessions.

James Bullard, who is now among the most hawkish at the Fed, previously commented on our Behind the Markets podcast that there are always economists who tried to rationalize the inverted curves, and they were wrong. why are you ignoring this indicator now? He issued no dissent to the ruling.

There is way too much groupthink at the Fed. In one of the most tumultuous times of monetary policy in history, it has been very disappointing that practically no dissents occurred all year long. Is there no one at the Fed who believes the Fed is overly tightening and sending us into a deeper economic slowdown and recession than necessary?

Further, we keep hearing about wages from Powell. Workers are trying to catch up with inflation and have still fallen behind inflation. Powell said something new at this recent press conference that there was a structural shift for a lower labor supply. What happens in Economics 101 classes when there is less supply and constant demand for labor. Most students would respond ‘wages must go up.’ I always thought the labor force participation rate was not returning to the levels prior the pandemic and Powell is also coming to that conclusion. But should he try to adjust a downshift in labor supply by tightening policy to bring down wages? No!

The Fed can impact demand by raising the cost of money, not the labor supply. And the Fed should let workers catch up to inflation, not crush their wages by overtightening.

Let me give an example to drive this point home. If there was a drought and weak crop output so that wheat supply dropped 15%. What would happen to prices? They would rise. Should the Fed clamp down on this inflation by raising rates? Little good that would do to increase wheat supply.

The markets rightly came under pressure with this misguided Fed policy, but arguably they would come under even more pressure if they believed Powell was going to follow thru with what he is saying right now. The inverted yield curve and the 2-year bonds shows the market skepticism the Fed will stay as tight as they claim. I believe next year can be a better year for the markets, but the Fed needs to back track on their tightening regime. The longer the Fed fails to recognize that the inflation fight is over, the sharper our slowdown next year will become.