March rounded out a quarter in which the equity market was cheered by the prospect of lower interest rates despite rising rates across the yield curve. Members of the open market committee, the arbiters of interest rate policy, continue to espouse three rate hikes this year despite continued solid economic growth. Given that backdrop, it appears that Chairman Powell and his fellow committee members are as wrong on their interest rate forecast as they were when they tried to calm concerns when inflation first appeared three years ago. The calming words that inflation would prove “transient” quickly devolved into the worse inflationary impulse in decades. Then at the December 2023 FOMC meeting the committee forecast that the rate rising cycle was not only over but expected to reverse much of the rate rise over the coming two years, with the first rate cut coming in March 2024.

With February upon us it may seem odd to revisit the December open market meeting, but the January employment report and the recent 60 Minutes interview of Chairman Powell has us wondering, “what were they thinking?” What we refer to was the dot-plot indicating three rate cuts this year. We’ve never been in favor of the Fed publicly forecasting their expected course of action and this is exactly why. After leaving the overnight rate unchanged for two consecutive meetings, bond investors assumed by their lack of action that they were probably done with the rate hikes. But rate cuts weren’t really on anyone’s radar. Speculation started to creep into the market in November as managers anticipated that we had reached the peak in rates, but the Fed’s communication caused a sharp drop in interest rates across the yield curve. That narrative unleashed a torrent of buying that sent the 5-year note from just a shade under 5% all the way down to 3.8%.

As we close out the year, investors seem to have concluded that the Federal Reserve has mostly accomplished their mission of containing inflation while simultaneously achieving an economic soft landing. We agree with the consensus. Year-over-year, the consumer price index was 3.1% in November, and we think that getting back to the Fed’s target of 2.0% will prove elusive for a few reasons. Principally, the changing workforce. The workforce is shrinking as the baby-boomers age out, and as it shrinks workers are finding they hold wage bargaining power, as evident by recent union gains and the rising minimum wages. To maintain profit margins, companies are forced to raise prices which creates the dreaded wage-price spiral. The Fed had hoped to avoid the occurrence by slowing the economy, but structural forces have prevented any slowing to date. Instead, the Fed is likely to need to raise their inflation speed limit to 3%.

The minutes of the September 19-20 FOMC seemed to reflect the committee members’ belief that they’re in the process of achieving the first ever economic “soft-landing.” Comments from the minutes included “Bank credit conditions appeared to tighten somewhat…but credit to businesses and households remained generally accessible,” and “The imbalance between labor supply and demand appeared to be easing.” As expected, the text echoed the answers delivered by Chairman Powell at the post-meeting press conference. There is a chance of one more rate hike this year and that rates will be held at an elevated level for an extended period. In short it read as though the committee was taking a victory lap for their engineering of a soft landing. Bond investors were delighted by the verbiage as witnessed in the collapse of the yield curve. The yield on the 10-year note fell to 4.55% on the day.

There’s a lively debate between those that believe that economic growth is slowing and those that believe it’s reaccelerating. The actual outcome will have a marked impact on the progress made to date on inflation. Clearly, employment growth has slowed from the torrid pace witnessed earlier this year. The July nonfarm payroll report registered the first back-to-back sub-200,000 growth since December 2020. Similarly, the jobs availability measure (JOLTS) has contracted to less than 10 million from the 12 million touched earlier this year. But with 9.5 million unfilled jobs still available it seems unlikely that the economy is on the verge of a significant stumble. On the other hand, retail sales for July paint a picture of a confident consumer seemingly unworried about income and willing to spend. That creates a conundrum for economists. Clearly certain industries, namely housing and autos, have slowed down or are in outright recession, but that has failed to impact consumption.