The Fed’s Dual Mandate: Success, But Trending in Opposite Directions
Economists and investors alike have been pleasantly surprised by the resolve of the US economy in the face of a largely unprecedented interest rate shock. Approximately one year ago, in mid-2023, over 50% of economists surveyed by the Wall Street Journal were forecasting that a recession would occur within the next 12 months. As of July, that number sat at just over 25% of economists. 1The Wall Street Journal. https://www.wsj.com/economy/central-banking/where-do-economists-think-were-headed-these-are-their-predictions-b3db91ea. That’s certainly indicative of a brighter economic outlook.
But the current US economic landscape is really a tale of two themes moving in opposite directions: (1) stubbornly high inflation, gradually drifting back down to more sustainable levels; and (2) a tight US jobs market, starting to show cracks as a result of the Federal Reserve’s aggressive interest rate hikes. Both promoting stable prices and maximum US employment are components of the Fed’s “dual mandate”. As the macroeconomic climate evolves over the coming months, Fed decision makers will have to make important tradeoffs in balancing these two objectives. For now, the Fed seems to have successfully tamed inflation with fairly minimal impact to the labor market (a praiseworthy feat should the US ultimately avoid recession), but the two key components of its mandate are currently trending in opposite directions.
Let’s start with inflation. The Consumer Price Index (inflation) has been gradually declining toward the Fed’s 2% average target—a welcome sight for Chairman Jerome Powell. A variety of different cuts of CPI also show easing inflation pressures. This first component of the Fed’s dual mandate has largely been in focus since inflation began surging in 2021. A combination of the Fed’s aggressive monetary policy actions, supply chain normalization, and an exhaustion of pandemic-era fiscal stimulus are all important contributors to the recent inflation reduction. Refer to the figure below from the Cleveland Fed. Of course, though the year-over-year inflation rate has clearly been falling, the cumulative impact of high inflation over the last few years has pushed aggregate prices up well above where they sat before the pandemic (not shown in the figure below). These higher price levels have been a source of pain for US consumers, and in particular, for lower-income consumers who haven’t participated to the same extent in the massive wealth creation from rising home prices and a booming stock market over the last few years.
Source: Federal Reserve Bank of Cleveland. Data are through June 2024. The 16% Trimmed-Mean CPI is a weighted average of one-month inflation rates of components whose expenditure weights fall below the 92nd percentile and above the 8th percentile of price changes. https://www.clevelandfed.org/indicators-and-data/median-cpi.
On the other hand, the US labor market, representing the other half of the Fed’s dual mandate, is still in good shape though is trending in the opposite direction of inflation (in other words, the wrong direction). The most recent employment report for July was recently released. Total nonfarm payroll employment increased by 114,000, a marked slowdown from June. Notably, the unemployment rate ticked up to 4.3% from 4.1% in June. 2 U.S. Bureau of Labor Statistics. https://www.bls.gov/news.release/empsit.nr0.htm.
Although many important labor market metrics currently sit at levels that are still reasonably strong, most are also moving in the wrong direction. For example, US job vacancies are declining, and other more granular statistics like those who have been unemployed for over 27 weeks (“long-term unemployed”) and those currently working part-time but can’t find full-time employment (“part-time for economic reasons”) are ticking up. In balancing inflation and employment, the Fed’s attention is now shifting to emerging weakness in the labor market, with short-term interest rate reductions likely coming at its upcoming policy meeting in September.
So where does this leave investors looking ahead? The US economy has continued to chug along, with surprisingly strong growth of 2.8% in the second quarter of 2024. 3 Bureau of Economic Analysis. https://www.bea.gov/data/gdp/gross-domestic-product. The US markets, however, have also been a pleasant surprise—bolstered by hype around artificial intelligence, declining inflation, and anticipated cuts to the federal funds rate. As I write this letter, even with the recent market volatility we just experienced, the S&P 500 has still delivered a year-to-date total return of 9.6% as of August 5th. 4 Data is from Morningstar.
However, caution is warranted in assuming these strong returns will continue on the same trajectory. Corporate earnings reports for the second quarter are currently underway, and investors are beginning to question the viability of massive artificial intelligence spending from some mega-cap technology companies that have been powering the US equity market. As my colleague Fred Snitzer recently wrote, the upcoming US election is a significant source of angst for many and may set the US on two divergent paths moving forward. The world itself is not as stable today as it was in the pre-pandemic era, with geopolitical tensions rising (and escalating into armed conflict) around the globe.
Looking ahead, PMA’s Investment Committee does expect heightened volatility in our clients’ portfolios due to the factors above, amongst others—Monday, August 5th was a good, albeit extreme, reminder of what “heightened volatility” can look like. But this is the reason why PMA believes a well-diversified portfolio is the best path forward. The US has dominated the financial markets since the Global Financial Crisis of 2008-2009, but there’s certainly a possibility that international equities begin to outperform in the near-term given where US equity valuations currently sit. The same can be said for US large-cap stocks relative to US small-cap stocks. Trends in the investment management industry ebb and flow through time, and a core tenant of our philosophy is that investors who are diversified across asset classes, geographic regions, and industries are well-prepared for the unknowable future.
