“The Time Has Come,” the Walrus Said.

It is apt today, as we await with anticipation the decision next week regarding a possible reduction in the level of the Fed Funds’ rate, to replace “the Walrus” with “Jerome Powell,” the current chair of the Board of Governors of the Federal Reserve System (the Fed).

The Fed has made it abundantly clear over the last two years that its actions regarding interest rates were (are and will be) guided by its duel responsibilities of (a) preserving the purchasing power of the U.S. dollar, i.e., maintaining price stability, and (b) promoting maximum employment. Note: Prior to 1978, the Fed’s role was limited solely keeping inflation under control. However, when the price of oil quadrupled in the early 1970s, resulting in soaring inflation and economic recession, Congress added the responsibility of “promoting employment” to the duties of the Fed. Over the forty-five plus years since the passage of that bill into law, balancing those two responsibilities has at times been challenging. However, since 2021, when the COVID-19 pandemic wreaked havoc with the global supply chain, inflation has been the challenge.

Inflation in this country is most commonly measured by the Consumer Price Index (CPI), a composite based upon a representative basket of goods and services. As we all know, however, inflation is very particular to one’s own circumstances that include geography—whether one is a city dweller, or living in the suburbs, or in a town in the open countryside; the status of one’s health; whether one owns a home outright, or is paying down a mortgage, or is a renter; the needs for travel/commuting, and, perhaps most importantly, one’s age. That basket of goods and services, one that is deemed to be representative of the country as a whole, is far from the actual experience of individuals and families. Two important components of the CPI are food and energy, both of which are essential costs for everyone, even those who don’t own an automobile, but must pay their utility bills. The demand for those two constituents are fairly price inelastic. The price of food has been particularly alarming over the last several years, but much of the inflation has been the result of exogenous forces. The Russian invasion of Ukraine in early 2022 had a multi-year impact on the rise in the prices of wheat, barley, seed corn, sunflowers and oils, as well as other food commodities. In addition, what used to be anomalous weather disruptions—extreme heat, floods and droughts—have become more the norm in the last few years, adding to the scarcity of food on a global basis and the volatility of prices. And here in the USA, avian flu has led to commercial egg farms having to euthanize their flocks. The impact of those cutbacks is expected to continue into at least early 2025.  

In the manufacturing and industrial sectors of the U.S. economy, the prices of many products have dropped significantly from their supply-constrained highs two years ago. That inability to ship billions of dollars of overseas production to this country brought about a change of heart by a large number of U.S. companies (90% of North American manufacturers, by one investment bank’s report) regarding their long-held trend of outsourcing production to facilities in foreign countries where lower wages offer a competitive advantage. According to some reports, more than one million manufacturing jobs—in industries as varied as electronics, automotive parts, semiconductors, consumer soft goods, and health care items—have been repatriated to this country in the last four years in an effort to shorten the supply chain. Those new jobs have been part of the reason for the continued robust employment in this country. In the short run, however, that shift from foreign to domestic manufacturing has added to the price of the final product, as hourly wages in this country are often multiples of those overseas. The advent of AI, however, has already begun to have a favorable impact on productivity in numerous industries. That trend will undoubtedly expand for decades to come, resulting in enhanced profitability and reduced inflation. Productivity gains also allow for increases in wages of the same magnitude without incurring an inflationary cost for the company.

The speed with which the Fed raised interest rates—from near zero in February of 2022 to 5.50% less than 18 months later—had the desired impact on inflation, which cratered from 9.1% (in July 2022) to 2.5% today, a whopping full 6.6 percentage points in two and a half years! That is an unprecedented decline in inflation. Throughout this period of decline in the rate of inflation, the Fed Funds rate has remained unchanged at 5.50%, with the result that“real” interest rates today are very high. An extended period of high real rates could indeed become a recessionary threat at a time when there is no urgency to slow down economic growth. The telltale signs of over-expansion in the economy do not exist today—inventories are not out of line with trendline economic growth; both corporate and household balance sheets are healthy. Employment is strong, and as productivity increases, it will provide the opportunity for continued economic growth at a rate faster than employment. Those are all signs of a healthy economy. It is true that the trend for years has been that Federal debt continues to grow faster than the country’s GDP. As of June 2024 it stood at 123.8% of GDP, which is down from an all-time high of 130.6% in 2020 during the COVID pandemic.  However, allowing the economy to spill into a recession will do nothing to reduce the Federal debt. As I write this column, we are still days—and mountains of data—away from the September 17 – 18 Federal Reserve meeting at which it will make a decision about interest rates. The histrionics of the stock market, from my point of view, are silly; extrapolating every piece of economic data in a straight line into the future is a fool’s errand. The data in general present a picture of moderate inflation, an excellent level of employment, a healthy consumer and a favorable environment for growth in corporate earnings. All good news!

In my February column, I wrote that the time had come and gone for a recession. I continue to believe that, even more strongly today. The only thing that could jinx that prediction would be if the Fed deliberately allowed real interest rates to remain high. There is no indication that the Fed has that intention; in fact, various Federal Reserve Bank presidents have all but said that a rate cut is likely, with the caveat that the decision will be data-driven. I remain convinced that there is a high likelihood of three interest rate cuts between now and next February and I will be happy with .25% in September. Cassandras will always find something to complain about with the state of the economy. But the preponderance of the data tell a good story and one that should get even better over the next year. Take a deep breath and carry on.