Pain. That is how Fed Chairman Powell described what is needed for combating the current inflation disposition. There is a choice, however: Pain now, or a lot more pain later. The Federal Reserve is intent on quelling inflation; its #1 priority. The pain that will be felt is going to be lower employment levels along with reduced economic activity.
The message was read loud and clear by the markets. Bond yields moved higher and stocks sold off. While I have been focusing on the events that will be occurring in the future, I was not expecting the delivery that we just received by the Federal Chairman.
The message is going to be this: Bond yields are heading higher; much higher. This will contract economic activity as personal incomes decline along with consumption. Employment rates, which have been very hot as of late, will start a progressive move lower. These moves will help give time to companies so that they can recoup their supply levels. Higher supply levels will mean prices can start to move lower.
Simultaneous to the news conference, economic data for inflation and personal incomes & personal expenditures arrived.
Inflation numbers are showing diverging metrics. Headline inflation is heading higher, but this includes gasoline and food. Core prices are heading lower – as the charts above show. I would expect that these numbers will continue lower as the inflation will begin to abate.
But, and this is my core thesis on this: Inflation is not magically going to move down to 2% overnight. This will take time. If inflation were to drop precipitously, i.e., a hard landing for the economy, then the economy itself will suffer significantly.
But, as best they can, the Federal Reserve will try and orchestrate a soft landing. Because of this they will always lean toward less increases in interest rates in order to keep the economy moving forward. But, this easier pace, being drawn out over a longer period of time will mean lower growth rates moving forward over a longer period of time.
This negates the more pain later comment.
Personal Income & Personal Expenditures
We are still looking at personal incomes and personal expenditures that are distorted from they hyper-increases from the stimulus checks. This will likely take many additional months to work their way through. The real focus will be the inflation numbers above. And, this will play out with increased interest rates weighing on consumption and, ultimately, labor rates.
Bond Yields & Stock Market Reaction
Bond yields are going higher. Stocks will fall. While I am writing this during market hours, the market moves will continue over the course of the coming months and quarters. The 2-year note is going to break to the upside. However, the 10-year note, although the rate will increase, it will do so at a slower pace since the eventuality is that once the Fed is done tightening its grip on the economy, they will then move to lower interest rates. Because of this, the 10-2 spread is negative and currently widening.
I expect this to continue and I expect the bounce we have just seen in the stock market will evaporate very quickly. I also expect a lot of sideways movements as the economy shifts and adjusts.