Control Panel: In transition

Transitional stages are always uncertain.

The Macroeconomy is in transition between the Covid-perturbed state and post-Covid normality. Between high inflation and (hopefully) the Federal Reserve’s target of 2%. Between the past decade of low-inflation, high-efficiency globalization and a new paradigm of world trade based on a model of more secure, local supply chains and national security considerations.

Why It Seems Everything We Knew About the Global Economy Is No Longer True

While the world’s eyes were on the pandemic, the war in Ukraine and China, the paths to prosperity and shared interests have grown murkier.
By Patricia Cohen, The New York Times,
June 18, 2023

“Nearly all the economic forces that powered progress and prosperity over the last three decades are fading,” the World Bank warned in a recent analysis. “The result could be a lost decade in the making — not just for some countries or regions as has occurred in the past — but for the whole world.”

A lot has happened between then and now: A global pandemic hit; war erupted in Europe; tensions between the United States and China boiled. And inflation, thought to be safely stored away with disco album collections, returned with a vengeance…

“Our supply chains are not secure, and they’re not resilient,” Treasury Secretary Janet L. Yellen said last spring. Trade relationships should be built around “trusted partners,” she said, even if it means “a somewhat higher level of cost, a somewhat less efficient system.”… [end quote]

Our government has moved in several ways to shift the equilibrium toward national security considerations even if globalization would provide cheaper imported goods. This increases costs, which increases inflation. That adds to the burden placed on the Fed. Now there are three forces on inflation – monetary policy from the Fed, fiscal policy from Congress and the weight of government control due to national security. The Fed is trying to control inflation but its only tool is monetary policy.

The Fed did not raise the fed funds rate at the June meeting last week.

Press Release, June 14, 2023

Federal Reserve issues FOMC statement

Recent indicators suggest that economic activity has continued to expand at a modest pace. Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated.

The U.S. banking system is sound and resilient. Tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain. The Committee remains highly attentive to inflation risks.

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. In support of these goals, the Committee decided to maintain the target range for the federal funds rate at 5 to 5-1/4 percent…The Committee is strongly committed to returning inflation to its 2 percent objective…The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee’s goals…

FOMC Projections materials

Variable 2023 2024 2025 Longer run
Change in real GDP 1.0 1.1 1.8 1.8
Unemployment rate 4.1 4.5 4.5 4
PCE inflation 3.2 2.5 2.1 2
Core PCE inflation 3.9 2.6 2.2
Federal funds rate 5.6 4.6 3.4 2.5
Difference between fed funds rate and PCE inflation 2.4 2.1 1.3 0.5
[end quote]

The Fed predicts slow real GDP growth but not a recession. Unemployment is forecast to be higher than it is now, though low by historical standards.

The April 2023 PCE index was 4.4 %. The Fed predicts a decline which may or may not happen.

The Fed predicts a slightly restrictive real fed funds rate through 2023 and 2024. They predict a “neutral” rate in the longer run – 0.5% – which would not slow or stimulate the economy.

The important takeaway is that the Fed will raise the fed funds rate later in 2023 if inflation doesn’t decline as they predict. Even if inflation does decline, the Fed intends to keep a fed funds rate that is significantly tighter than their ZIRP emergency rate for at least 2023 - 2024. That will directly impact interest-rate sensitive businesses, such as zombie companies with maturing debt, so-called “growth” companies without cash flow and commercial real estate by raising all interest rates.

The stock market responded to the Fed’s pause by celebrating. They shrugged off the Fed’s implication that it could raise the fed funds rate at least once later this year. Economist Paul Krugman (a cheerleader for “Team Transitory” from the start) uses his preferred measure that he calls “super core,” which excludes both used car prices and shelter in addition to the Fed’s preferred measure that excludes food and energy prices. That’s because nobody uses food, energy, shelter or used cars, right? But he gets the result he wants – lower inflation.

That doesn’t matter to bond investors with inflation adjustments based on the CPI. But it could influence the Fed…and the markets.

The trade is strongly risk-on. The Fear & Greed Index shows that the market is in Extreme Greed. The Price-to- earnings ratio of the S&P500 based on average inflation-adjusted earnings from the previous 10 years, known as the Cyclically Adjusted P/E Ratio (CAPE Ratio) has bounced up to over 30, double the historical median of 15.

A little air was let out of the stock market bubble but not much … and it’s inflating again. Growth stocks are dramatically outpacing value stocks, driven by the inflation of a handful of tech giants.

The Treasury yield curve has risen along the mid-maturity range.

Gold, silver, copper, oil, natgas and USD are stable in their channels.

Even if economic growth is slowing, employers are not laying off workers as in previous recessions. Instead, they are cutting hours. Since the labor market is so tight they want to hold onto their workers for the recovery they anticipate.

The METAR for next week is sunny.