By most measures, the U.S. economy is on firm footing and growth is accelerating into 2018. Over the second half of 2017, our economy grew at an annualized rate of 3% while the U.S. unemployment rate has ticked down to 4.1%, its lowest level since the early 2000s. The recently enacted tax cuts will add further fuel to the fire in 2018. Counterbalancing the country’s strong economic growth, however, is a deterioration in its financial position. Our national debt is now over $20 trillion and our annual budget deficit may approach $1 trillion in fiscal year 2019.
But while rapid economic growth may sound good, many investors would prefer to invest during a period of low-to-moderate economic growth along with stable interest rates and subdued inflation. Rapid growth can certainly provide a tailwind to corporate profits in the short run, but it also is a less stable trajectory. As growth heats up, so too do inflationary pressures.
Jerome Powell, who was sworn in as Chairman of the Federal Reserve on Feb 5th, has a task ahead of him that may prove to be just the opposite as that of his predecessor, Janet Yellen. Fed Chair Yellen, through much of her tenure, advocated loose monetary policy (low interest rates) to support the economy and to try to stoke a bit of inflation. Mr. Powell, however, may have to act decisively to contain it.
The Fed has an inflation target of 2%. Central bankers much prefer some inflation to deflation. Inflation has a “cure”—raising rates—while deflation can be very hard to escape. Moderate inflation also has the effect of decreasing the real cost of servicing debt, while deflation makes debt more onerous in real terms.
In the years since the financial crisis of 2008-09, central banks around the world kept policy interest rates very low and employed other tactics, such as buying back government bonds in the open market, in an effort to keep long-term interest rates low and to thereby stimulate economic activity. A few years after the crisis lows of 2009, central bankers began to scratch their heads as to why inflation remained so low in the face of their vigorous measures. Economic growth across the developed world in the post-crisis years remained positive but anemic, even while unemployment rates fell. Wages remained stagnant.
On January 26th, investors got their first strong whiff of brewing inflation. Wage growth was up 2.9% from last year, a stronger-than-expected reading. Wages are a major ingredient in inflation. As the unemployment rate drops, employers are forced to raise wages to keep their workers. As labor costs rise, these costs are passed along to customers in the form of higher prices. As prices for goods and services climb, bond investors will demand a higher interest rate in exchange for holding long-term bonds. Who wants to hold a 10-year U.S. Treasury note yielding 3% if inflation is 3%? Investors will demand some return above inflation to compensate them. As long-term interest rates rise, they put pressure on the prices of assets such as stocks, bonds and real estate.
All of a sudden, after years of consternation about below-average growth, investors are facing a new concern: growth that is too high and the attendant inflation that will come with it. Fed Chairman Powell can be likened to a man sitting in a car (the U.S. economy) heading downhill at 50 miles per hour that is rapidly picking up speed. Ideally, Mr. Powell would like to keep the car under control by tapping the brakes occasionally so that the car ends up coasting smoothly along at 70 mph. If he brakes too hard too early (by raising interest rates either too high or too quickly) the car will come to a jarring halt and a recession will result. If he does not brake enough in the near term, the car will continue to pick up speed until Mr. Powell is forced to really slam on the brakes later if he wants to keep the economy out of the inflation ditch.
This part of the economic cycle can be strange for investors, as it is a time when bad economic news can be good for asset prices and good economic news can be bad for prices. For example, if the economy adds jobs next month at a much faster pace than expected, stocks and bonds will likely react negatively, as investors will anticipate a quicker and more forceful tapping of the brakes from Mr. Powell and the Fed.
On Tuesday Mr. Powell testified before Congress for the first time and confirmed his intention to continue to gradually raise short-term interest rates if the economy remains strong. His bullish outlook for the economy may mean more rates hikes sooner. The Federal Reserve looks to have a starring role in 2018’s market drama.
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