The economy has reached an inflection point as the Federal Reserve changes monetary policy to reduce prevailing short-term interest rates by embarking on a program to cut the Federal Funds rate. How the economy will change after this point remains to be seen. Will the economy need continued support to head off recession? Will rate reductions in a strong economy promote inflation, or will the Fed be able to fine-tune the economy as it normalizes without any adverse reaction?

The Economy

Inflation as measured by the Consumer Price Index was reported as 2.6% through August. The Federal Reserve’s Personal Consumption Expenditure price index increased 2.2%, and consumer expectations for the next three years are running around 3%. It has also seen the unemployment rate climb slowly to 4.2% over the last year. Unemployment is not excessive though, and is well below its 76 year average of 5.7%. All in all, both inflation and unemployment are historically quite normal. Based on their readings of inflation and the demand for labor though, the Fed decided inflation is sufficiently controlled and more attention should be paid to the labor issue, prompting the decision to “recalibrate” their policy and reduce short term interest rates.

The economy has proved resilient despite the Fed’s anti-inflation program, with the GDP growing by 3% during the 2nd quarter of 2024. The current growth expectation is more of the same, with an Atlanta Fed’s “GDP Now” estimating 3.1%. The service economy is strong, while manufacturing conditions are still somewhat depressed, suggesting that the reported GDP growth is rooted in the service economy.

The interest rate policy change has already decreased the return on money market funds and many bank accounts. It has also decreased the 30-year mortgage rate to 6.08%. This should start loosening up the housing market as people who have been hesitant to move and take on a higher mortgage decide to sell current housing.

The Markets

The shining “Magnificent 7” large capitalization growth stocks lost some of their luster during the third quarter. The group performed almost 8% worse than the equal weighted version of the S&P 500. You may recall our comparison of the two and our conclusion in the last issue of Outlook & Trends. Bonds performed well, anticipating the Fed rate cut, and then sold off a bit after the policy change was announced. Interestingly, one of the stronger performers in the lead-up and aftermath of the rate reduction was gold, which had a 6% gain during the month. The increase in commodity prices may suggest either expectations of higher demand due to stronger future economic activity after the Fed policy change, a price markup due to an expected return of inflation, or both.

An Inflection Point

The last fourteen years have witnessed unusual and aggressive government financial policies, beginning with the repeated rounds of Quantitative Easing (“QE”) and followed by excessive spending programs. The QE policy drove interest rates lower than ever before to stabilize and boost the economy after the 2008 recession by encouraging companies and individuals to acquire new debt to spend and to refinance old loans. The pandemic elicited a historically strong reaction of debt-financed excess government spending through handouts of “helicopter money” followed by infrastructure spending legislation.

Both of these policies achieved their goals, but not without side effects. QE drove up stock and bond market values to historic levels. This was good for investors at the time, but likely will not be good for investors’ future returns. Likewise, the pandemic handouts, while shaking the economy and the markets out of their sharp downturns, created an inflationary environment not seen since the 1970s.

To fight inflation, the Federal Reserve adopted a ‘higher for longer” interest rate policy. This approach has often caused recessions. This time, however, companies had refinanced their debt at low rates and also benefitted from the infrastructure spending bills. Additionally, individuals were able to spend the money that had been given to them earlier by the government. These forces counteracted the higher interest rates and kept the economy growing. As the effect of this extra support winds down, the Fed has begun to see some softness in the labor market and has determined that the risk to the labor market and inflation risk are now in balance. They have adopted a new policy of “normalization” by beginning to reduce their Federal Funds rate to what is called the “natural rate” of interest. The natural rate neither stimulates nor constrains the economy. The current estimate of the natural rate is 2.6%.

Normalization should be welcome after years of abnormal policy. However, a normalization policy is likely to be most successful when it starts from normal or below normal economic conditions. Current conditions are clearly not normal. Although improving from the depths of the pandemic, the money supply (”M2”) remains a far greater proportion of GDP (73%) than normal. The highest proportion from 1965 through April 2011 was 60%. The government’s level of debt continues to inflate as the budget deficit continues to grow. It is currently 123% of GDP, while a level over 90% is thought to be detrimental, according to an often referenced study by economists Reinhart and Rogoff. The average interest rate for a 10-year treasury note was 5.9% during the period since 1965. It is still currently well below that at 3.75%. The average long-term Shiller’s Cyclically Adjusted Price Earnings ratio of the S&P 500 stock market index was 16.4 from 1886 to 2010, before the current policy experimentation. Today it is 35.2. These are still not normal times. Although the future is likely to be affected more by eventually reverting to the long-term economic averages than by a short term normalization of Fed policy, the process must start somewhere.

Over the short-term, presidential election years typically show positive investment returns, and this one certainly has. The equal weighted version of the S&P 500 has risen 13% this year, and the current trend appears to continue to be strong with more room to run. October has historically been a tough month however. In the last four presidential election years, neither stocks nor bonds had a winning October. In these years stocks were down 5.5% on average during October, and the 10-year Treasury bond was down 1%. November and December provided a reversal though. Stocks averaged a gain of 4.5%, while bonds gained 2.2%.

While the Fed has provided a policy change that will be an inflection point and set a new course, it remains to be seen what the outcome will be. Without another financial crisis, it will probably not be a return to minimum interest rates, but it can safely be said that interest rates on bank and money market savings are likely to fall over time toward the neutral rate. If we have a recession in our future due to the lagging effect of the higher rates, the yields on longer term bonds will also fall and their prices will rise, which would make bonds the investment of choice. On the other hand, if government stimulus is maintained within the current context of a strong economy and lower interest rates, stock prices will likely rise further, which would be good for now, but become even more overvalued and risky for the long term. That outcome would also re-stoke the inflation fires. This was the scenario played out in the “stagflationary” (economic stagnation plus inflation) period in the 1970s.

As is often the case, the financial outlook is unclear and may resolve itself with a number of different outcomes. That is the reason that LFM&P suggests developing, maintaining and executing an adaptable financial plan that is consistent with your vision of your economic future and your expectation of the inherent possibilities and risks.