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Chief Economist Eugenio J. Alemán discusses current economic conditions.

The Federal Reserve (Fed) and the markets have continued to go at each other to try to impose their view of what needs to happen with interest rates and their views seem to be highly divergent. We have already argued that the economic cycle we have experienced over the last several years is not something we have seen before. That is, if the economic cycle is different than what we have seen for the last 40 years, the approach to this cycle has to be different also.

However, markets believe that this is a typical cycle, a cycle in which the Fed sees the economy weakening, with the rate of unemployment increasing, and it starts lowering interest rates. This is not what the Fed sees, and we have been writing about this for some time now (see our Weekly Economics for January 13, 2023). This is the reason why we continue to believe that the Fed will keep interest rates higher for longer.

The question today, and for the last year, has been how high the Fed is going to go. However, what markets seem to not understand is that the answer is in the hands of the market, not the Fed. The more markets try to push long-term interest rates down, the more the Fed will tighten monetary policy, period!

You would probably ask why. Because the Fed has control over only one rate of interest, the federal funds rate. All the other interest rates are determined by market forces. The Fed can try to ‘guide’ the markets to what it wants them to see, but markets are, many times, stubborn, and don’t want to believe what the Fed is trying to convey. This is one of these times.

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In particular, the Fed is probably very disappointed that the 10-year Treasury yield came down and mortgage interest rates followed over the last couple of months. This decline in mortgage rates has translated into an improvement in some housing market measures such as new home sales, while the decline in existing home sales seems to have moderated considerably over the last several months. This is not what the Fed wants to see, as the housing market is one of the sectors the Fed targets when conducting monetary policy and in some markets, home prices were looking too ‘frothy’ as former Fed Chairman Alan Greenspan liked to say.

This stabilization in the housing market has other potentially negative effects, which will play directly into the Fed’s ability to bring down inflation to the 2.0% target: shelter costs. If home prices stabilize and or financial conditions improve, then there is a possibility that shelter costs will not weaken enough to help bring down inflation.

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Killing a Fiscal Cycle with Monetary Policy: How Is that Going?

As we have argued several times, what the U.S. economy went through during the last several years was not a typical monetary cycle. In fact, it wasn’t a monetary cycle at all. Yes, money supply grew by an almost exorbitant amount (by U.S. standards!), but it wasn’t because the banking system created money through the lending process. It was an amazing increase in money supply created by fiscal policy, that is, transfers from the federal government to Americans.

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This is why the Fed is having trouble killing the U.S. economy using its traditional method of tightening monetary policy by increasing the federal funds rate. Although lower income Americans may have probably already ran out of excess savings accumulated during the COVID-19 recession, middle income and higher income Americans continue to have access to these excess savings and have kept the service side of the economy going. Furthermore, because the labor market has remained very strong and inflation is finally coming down, real disposable personal income, which had been declining over the last year or so, is starting to recover.

This means that if markets continue to fight the Fed and push yields on the 10-year Treasury down, the Fed will be pushed to continue to increase interest rates to try to cool down the economy, risking sending the US economy into a deeper recession than what we are expecting.

Thus, our message to the markets is: don’t fight the Fed!

Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those of Raymond James and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur. Last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the U.S. Bureau of Labor Statistics. Currencies investing is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample.

Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.

The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100.

Leading Economic Index: The Conference Board Leading Economic Index is an American economic leading indicator intended to forecast future economic activity. It is calculated by The Conference Board, a non- governmental organization, which determines the value of the index from the values of ten key variables

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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren’t part of this index.

FHFA House Price Index: The FHFA House Price Index is the nation’s only collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities that extend back to the mid-1970s.

Expectations Index: The Expectations Index is a component of the Consumer Confidence Index® (CCI), which is published each month by the Conference Board. The CCI reflects consumers’ short-term—that is, six- month—outlook for, and sentiment about, the performance of the overall economy as it affects them.

Present Situation Index: The Present Situation Index is an indicator of consumer sentiment about current business and job market conditions. Combined with the Expectations Index, the Present Situation Index makes up the monthly Consumer Confidence Index.

Pending Home Sales Index: The Pending Home Sales Index (PHS), a leading indicator of housing activity, measures housing contract activity, and is based on signed real estate contracts for existing single-family homes, condos, and co-ops. Because a home goes under contract a month or two before it is sold, the Pending Home Sales Index generally leads Existing-Home Sales by a month or two.

DISCLOSURES

Import Price Index: The import price index measure price changes in goods or services purchased from abroad by

U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).

ISM New Orders Index: ISM New Order Index shows the number of new orders from customers of manufacturing firms reported by survey respondents compared to the previous month.ISM Employment Index: The ISM Manufacturing Employment Index is a component of the Manufacturing Purchasing Managers Index and reflects employment changes from industrial companies.

ISM Inventories Index: The ISM manufacturing index is a composite index that gives equal weighting to new orders, production, employment, supplier deliveries, and inventories.

ISM Production Index: The ISM manufacturing index or PMI measures the change in production levels across the

U.S. economy from month to month.

ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers’ Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.

Source: FactSet, data as of 12/29/2022