Fed Pivot? Traders Thwarted Again As Inflation Just Won’t Go Away

They say in thirty years, a burger and fries could cost $16, a vacation $12,400, and a basic car $65,000… No problem. You’ll eat in. You won’t drive. And you won’t go anywhere.

TIAA-CREF advertisement (placed in The New Yorker in 1994).

Since the Fed began raising interest rates in 2022, traders have again and again placed bets on the world returning to the “normal” of the 2010s with 0% interest rates and low inflation. However, those bets have been repeatedly squashed by report after report showing that inflation continues to be a problem. Traders got more bad news this week with GDP and inflation reports that showed weaker-than-expected economic growth and prices continuing to charge higher. The stock market doesn’t seem to care. Stocks are up roughly 24% since their October lows despite S&P 500 (SPY) earnings only being up 3.5% year-over-year and roughly flat since 2022.

The most-anticipated recession in history hasn’t yet happened, but neither has the market-wide AI-driven earnings boom that sell-side analysts have called for. Stock market euphoria plus troubling economic fundamentals mean the Fed is forced to keep rates higher for longer. The biggest problem– inflation just won’t quit. The latest installment in the Federal Reserve soap opera is due next week when the FOMC meets for its regularly scheduled interest rate next week. The Fed’s latest interest rate decision and statement will be released at 2 pm ET on Wednesday, with Fed chair Jerome Powell’s press conference to follow.

Fed Pivot Bets Have Been Moved Back To September

As of my writing this, futures markets currently imply a 97.6% chance of the Fed keeping rates steady at its May meeting next week. Powell has indicated that this is the Fed’s intention, so there are unlikely to be any major policy surprises in this week’s meeting. Markets are currently pricing the first Fed rate cut in September, one meeting before the U.S. presidential election in November.

In other news, Donald Trump’s advisors have reportedly suggested taking control of the Fed for their own purposes if elected–to the alarm of the mainstream Republican establishment. And breaking with tradition, Biden earlier this month also had predicted that the Fed would cut rates this year, his comments breaking with the pre-Trump precedent of the White House not commenting on Fed policy. According to voters, inflation is the number one political issue in the upcoming election. Will Congress and the White House get the message? That’s the trillion-dollar question.

Earlier this month, the March CPI report roiled markets, with services inflation showing virtually no progress towards the Fed’s inflation target. In particular, increases in the price of home and auto insurance are squeezing consumers. Then, the GDP deflator numbers dropped another inflation bomb on the markets this week, while even the lowball core PCE numbers that the Fed likes to set its policy off of failed to provide any relief. Any way you slice it, inflation is still a big problem, and it’s going to stay that way unless the labor market materially weakens. With both presidential candidates likely to spur more inflation, the job falls to Powell to rein them in.

That means the Fed is going to stay on hold, and there can be no Fed pivot in the short run. Cash is currently paying about 5.4%, while inflation is roughly in the 3% range (current inflation estimates range from 2.8% on core PCE to 3.8% on core CPI). That should be enough to put downward pressure on inflation. But despite this, the data is still starting to trend in the wrong direction. It would be terrible for the Fed’s credibility here to start cutting rates into a budding inflation surge. Therefore, the only thing the Fed really can do here is hold. And if the data keeps getting worse (perhaps driven by excessive deficit spending), then there’s the risk that the Fed may need to start hiking rates again.

Econometric modeling using the Taylor Rule suggests that for now, the Fed has interest rates at roughly the correct level, as long as inflation doesn’t keep surging. I did some quick modeling, and I have 7 runs suggesting that the Fed should hike, 17 suggesting a cut, and 6 suggesting that the Fed should hold. One thing to note is that the inflation input here is the core PCE, so if you used the CPI numbers instead, the models would largely be saying to hike. Again, if inflation resurges as it did in the 1970s, the Fed would have to hike again, but I don’t see that happening yet. The Fed is continuing its quantitative tightening (QT) program, which helps reduce the amount of money in the system. There’s some talk that the Fed may reduce the pace of QT from its current pace of $95 billion per month, but my feeling is that they’ll leave the current pace in place for another meeting or two.

Hear No Evil, See No Evil

Another factor that I think is playing into the Fed’s reasoning is the fact that the stock market seems to have its earmuffs and rose-colored glasses on. Despite the AI boom hype– profit margins for the S&P 500 are actually lower than they were at this time last year. It’s not as if the Y2K-like AI spending boom for large corporations and governments doesn’t show up in the data– it does. Information tech is showing earnings growth of 20% year over year, while communications (i.e. Google (GOOG), Meta (META)) is showing 34% growth. But energy profits are down about 26% year over year. And so far, healthcare profits are down 28%. Earnings season is only about halfway over, but so far, you can’t look at this earnings season and think it’s indicative of a boom in the entire economy. Some of the companies that are missing on earnings are missing by unusually large margins.

The current tech boom strikes me as uneven and possibly ephemeral. For example, Saudi Arabia and the UAE are each spending billions in an AI arms race, and American companies are happy to sell them the equipment. Ironically, the massive data centers near DC are burning tons of coal every hour to power their AI fantasies, highlighting the fact that the resource constraints facing the economy are probably not from a lack of computing power. Economic history and theory say that when governments try to centrally plan their economies, they tend to get gluts of the goods that they’ve centrally planned for and shortages elsewhere. To this point, it wouldn’t be surprising for America in 3-5 years to see a glut of electric cars and semiconductors and 9% mortgage rates (due to the government crowding out the market for loans). They’d have the same root cause– deficit spending without raising taxes.

The best test of whether the boom in AI capex is likely to see results is whether the spending is being driven by fear or by need. In the early and mid-1990s, tech spending was largely driven by innovation. Investing in technology allowed businesses to make incremental improvements to their process and to do more work with fewer resources. However, in 1999 in particular, IT spending was in large part driven by fear. There was fear of Y2K and fear of being left behind, and the pace of spending picked up dramatically. Then as now, the Fed was trying to rein in a euphoric stock market. As is the case now, fundamentals then didn’t quite match the underlying economic data. And when cooler heads prevailed, business leaders realized that they massively overspent on IT. Now, fast forward to the present. 5 years ago, automation and AI were around and quietly improving productivity. Now, they’re being used as a Silicon Valley marketing campaign. The odds of investment being wasted are much higher in the current environment.

We could certainly debate the pros and cons of the current economic and market situation, but I just don’t want to pay 23x earnings for it. For whatever reason, investors have twice in the last 25 years whipped themselves into a frenzy about the prospects for the stock market, and twice panic-sold and drove prices down 50% when they realized en masse that they overpaid. Maybe the third time is the charm.

Bottom Line

Inflation is still a problem, and as a result, the Fed will likely need to hold interest rates higher and longer and for longer than traders had hoped. Investors will get another update from the Fed with this week’s FOMC meeting. For Corporate America, the status quo has prevailed for the last 18 months, with neither an earnings boom nor a collapse. With the Fed holding rates high and squeezing the economy some more to slow the rise in prices, it remains to be seen whether that will still be the case in 6 months.