It is apparently a done deal that the Federal Reserve has completed its monetary tightening cycle and is getting closer to cutting interest rates. There isn’t much disagreement on that. The heated debate has been about “When?” Timing is essential, but the more significant question is “By how much?”
On Wednesday, January 31, the Federal Reserve wrapped up a two-day meeting to determine the level of interest rates. It is now old news that they decided to stand pat and leave the federal funds rate at the range of 5.25 to 5.5 percent. I have learned over 35 years of investing that the stock market often has two reactions following significant news like that. The first is what we would refer to as the “knee-jerk” reaction. The second is a settling-in of the information and what that new data point really means for stock prices.
The knee-jerk reaction was a sell-off in the stock market. Investors seemingly focused on one particular sentence in the Fed’s statement: “The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward two percent.” In other words, the Fed said what I have been saying—investors are delusional if they expect the Fed to start cutting interest rates in March (the month of their next meeting). Those deluded investors pushed up stock prices in late 2023 and early 2024 in naïve expectations.
I have stated that the first half of 2024 could be rough for the stock market. A poor start to the new year would be consistent with presidential election years. Also, a sideways-to-negative move for the market would reflect that investors ran up prices in anticipation of interest rate cuts that would not occur for months after their expectations.
No matter how sideways or negative the stock market might be for the first half of 2024, all other things equal (which, I know, they never are), prices should get a tailwind in the later part of the year. When you read the Fed’s statements, watch the press conferences, and follow interviews and comments, you realize that the Fed doesn’t need to see inflation (as measured by the Core Personal Consumption Expenditures (PCE) Index) hit its two percent target before it lowers rates. The Fed needs “greater confidence” that the inflation rate is “moving sustainably” toward its target. If you annualize the last six months of Core PCE data, inflation is already below the Fed’s target. The Fed is confident that inflation is going in the right direction and will not resurge. But it simply wants to be more confident. I suspect they will find that confidence in the coming months.
Fed Chairman Jay Powell later explicitly said that they would likely not reach that level of confidence by March; however, he left open the possibility of a cut at the May 1, 2024 meeting. The odds of a cut in May 2024 is about 60 percent, according to the CME FedWatch Tool.
All other things equal (again, I know), I expect the Fed to take no action at the May meeting. However, I suspect their press conference rhetoric will be dovish enough that investors all but know a cut is coming at the June 12, 2024 meeting. (That is not a slam dunk; the Fed could surprise me with a cut in May.) And I suspect that cut would not come because the Fed needs to prop up the economy. I have reported in previous columns that the risk of a U.S. recession this year is fading. Instead, the Fed can complete its two-year-plus high-interest rate policy because the costs of goods and services are under control.
The lower the inflation rate, the lower the interest rate can go. The lower the interest rate, the more likely that stock prices will rise. Stable inflation will support stock prices in the second half of 2024.
The Federal Reserve affects interest rates in the broader market by setting the federal funds rate. The Fed raises or lowers the rate to achieve its dual mandate of achieving maximum employment and keeping prices stable. To do so, sometimes the rate is higher or lower than what economists call the “neutral rate.” The neutral rate (AKA the long-run equilibrium rate, the natural rate, or r*) is the short-term interest rate level consistent with an economy operating at capacity (i.e., full employment and stable inflation).
The neutral rate is part theoretical and part mathematical. The theory uses different equations; I wiill spare you the equations. According to two oft-used models, the Fed could lower rates to a range of about 0.9 to 1.2 percent and be at the neutral rate. The Fed’s own model estimates that the neutral rate is 2.5 percent and expects it to be achieved by 2026.
A 2.5 percent neutral rate compares to the Fed’s current range of 5.25 to 5.5 percent. Yesterday’s tightening is tomorrow’s stimulus. Assuming that the Fed can get us even halfway to the neutral rate in the absence of a U.S. recession, that would support stock prices. Recent data predict a still-growing economy. The Atlanta Fed GDPNow forecasts a 4.2 percent growth rate in the current quarter (though it’s early in the month, so expect revisions). On February 2, 2024, the Bureau of Labor Statistics announced a whopping net increase of 353,000 jobs created in January 2024. The unemployment rate remained at an impressive 3.7 percent. Rising unemployment is a hallmark of the “official” definition of a recession.
I would label two consecutive quarters of negative GDP growth a recession, even if employment remained stable. That is why I have claimed that the U.S. economy experienced a recession in the first half of 2022.
Having had that recession behind us, I disagreed with pundits, economists, business leaders, and households calling for an additional slowdown later in 2022 and 2023. I have argued, however, that the risk of a recession beginning before March 2025 was elevated due to a Federal Reserve misstep and the lag effect of higher interest rates.
In any given year, the historical average probability of a recession is roughly 15 percent. The risks remain higher than the average due to interest rates remaining restrictive and geopolitical tensions. The Federal Reserve calculates a 62.94 percent chance of a recession by the end of 2024. However, I assess something closer to a one-in-four chance of a recession beginning by March 2025. One reason my odds are lower than the Federal Reserve’s is that monetary tightening triggers fewer recessions than you might expect. DataTrek explains that Federal Reserve policy has “only” caused two of the last eight recessions (1970, 1982). DataTrek cites the causes of those eight recessions as:
- 1970: Government spending on the Vietnam War and Great Society initiatives increased inflation. The Federal Reserve raised rates from 5 to 9 percent in 1968–1969, causing a recession in 1970.
- 1973–1974: A Saudi oil embargo on Western countries that supported Israel during the Yom Kippur War lifted oil prices from $1 per barrel to $4 per barrel. A sharp economic downturn ensued.
- 1980: The Iranian Revolution curtailed global energy supplies, and oil prices doubled in less than a year. Throughout the 1970s, the price of a barrel of oil went from $1 to $40.
- 1982: With inflation running at 11 percent, the Volcker-led Fed raised interest rates to 19 percent, a record. This reduced the demand for housing and durable goods, and unemployment reached 11 percent in late 1982. This would be the highest level of joblessness since the Great Depression and until the 2020 Pandemic Recession.
- 1990: Iraq invades Kuwait, doubling oil prices in just a few months.
- 2001: The bursting of the dot-com bubble in 2000 caused a recession because of the negative wealth effect associated with lower stock prices, especially in speculative tech names where many retail investors were concentrated.
- 2007–2009: The 2007 Financial Crisis and a doubling of oil prices in 2007 due to excessive speculation made for what would later be called “The Great Recession.”
- 2020: The Pandemic Crisis caused a short but severe recession, ameliorated by aggressive fiscal and monetary policy.
The average federal funds rate from 1971 to 2023 was 5.42 percent. The current rate is at that level, which is somewhat comforting. However, the velocity of change is potentially more damaging to the economy than the level. I don’t rule out a recession starting by March 2025, but the risk of the Fed being the culprit is fading. I remain invested in equities, primarily domestic large-caps with a tilt toward the technology sector.
Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
