Fed Delivers a Little Dose of Reality

Stocks fell at the open this morning (Dow -600 pts; SPX -2.2%), led lower by technology and internet sectors. Commodities are mixed in early trading. WTI crude oil edged down to $92.20/barrel and gold fell 1.2%. On the other hand, most agricultural commodities are in rally mode. The bond market is moving in the wake of Federal Reserve Chair Powell’s speech in Wyoming (see below). Junk bonds are down about 1% but safe-haven Treasuries are rallying nearly that much. This suggests bond traders are less bullish on the economy.

Fed Chair Powell reiterated his view that interest rates should be ratcheted higher in order to fight inflation. “We must keep at it until the job is done.” While this should surprise no one, he also implied that rates might have to remain elevated for an extended period if inflation proves stubborn. His speech lasted all of eight minutes, but was sufficient to convince stock & bond traders that the current bear market may last a bit longer. His comments argue against the idea that the Fed will “pivot” away from interest rate hikes as soon as economic growth and inflation begin to slow. In a way, his speech puts investors in a tough position, calling into question the 2-month-long stock & bond rally. But what else can he do? Language is a very important Fed policy tool, and he must talk down the economy in order to break inflation. That is, he wants businesses to hire fewer workers and consumers to spend less in order to normalize what became a super-heated economy last year.

Right on cue, consumer spending did slow (a bit) last month. According to the Bureau of Economic Analysis (BEA), personal spending edged up only .1% in July following a 1% jump in the prior month. Part of the reason for that is lower inflation (-.1% in July). Prices declined for gasoline, furniture, consumer electronics & appliances. On a year-over-year basis, the Federal Reserve’s preferred inflation gauge slowed to 6.3% (from 6.8%), and inflation excluding food & energy decelerated to 4.6% (from 4.8%). But while we’re probably past peak inflation, the battle isn’t over. We’re witnessing a tug-o-war between two competing forces. On one hand, rising wages and a strong labor market encourage people to spend. On the other hand, high inflation and rising borrowing rates discourage people from spending. It remains to be seen whether the Fed can finesse these forces to drive inflation toward 2% without killing growth.

The University of Michigan’s consumer sentiment survey jumped unexpectedly this month. The index climbed to a 3-month high, signaling a bit more optimism about the future. The survey director noted “gains in sentiment…across age, education, income, region, and political affiliation, and can be attributed to the recent deceleration in inflation.”