November FOMC: Slower Not Lower

Executive Summary

• The Federal Open Market Committee (FOMC) raised the Federal Reserve (Fed) Funds rate by 0.75 percentage points at their November meeting, in-line with expectations, and also set the tone for slowing the pace of rate hikes in the near future.
• Despite hinting that the pace of hikes will likely slow, Chair Powell made it clear that this should not be perceived dovishly as the committee now anticipates hiking to a higher level than previously expected in September.
• Chair Powell also conveyed discontent with the progress made so far as the labor market remains too tight and demand continues to broadly exceed supply.
• The FOMC remains steadfastly focused on inflation as the asymmetry of risk suggests a preference for overtightening rather than not tightening enough and allowing elevated inflation expectations to become entrenched.
• “Don’t fight the Fed” as the saying goes, and we do not intend to. This continues to be a “sell the rip” rather than a “buy the dip” market. Remain defensive in multiasset portfolios. Nibble on duration, don’t bite.

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From How Fast to How High

Chair Powell made several items clear at today’s press conference: the FOMC will slow the pace of rate hikes, they are again revising higher their expectations for how high they will hike, and that they are aware and considerate of the lagged effects of tightening monetary conditions. Although many view the FOMC’s recently conveyed awareness of the lagged impacts of monetary policy as indicative of an upcoming pivot, we believe these interpretations miss the point that the asymmetry of risk for the FOMC points to overtightening rather than not tightening enough. Why? It’s simple. Inflation is both an economic and psychological phenomenon. Supply and demand imbalances drive inflation at first, but the longer inflation remains elevated, the more likely it becomes embedded in expectations; the more embedded in expectations inflation becomes, the more it guides the behavior of businesses and consumers, such as raising prices because competitors are and bargaining for higher wages. Inflation expectations are so important that Chair Powell actually stated in the press conference that although oil prices are set globally and not controlled by the Federal Reserve, it’s still important to give the public confidence that the Fed is “doing something” when energy prices are driving inflation. As a result, the FOMC may hike rates despite Chair Powell admitting that it will have limited impact on energy prices. This was a powerful statement that underscores the importance of being perceived by the public and markets as credibly fighting inflation in order to keep expectations anchored. Therefore, price stability (or at least the perception of fighting for price stability) trumps near-term recession risk. As we learned from the stagflation of the late 1960’s to early 1980’s, once runaway inflation becomes embedded it is extremely challenging to uproot and the economic consequences are dire. Understanding that unanchored inflation expectations is the primary risk the FOMC seeks to preempt is key to understanding their reaction function.

Into the Unknown

We have long thought that the FOMC does not know with any confidence how high they will need to hike interest rates to bring inflation back down to 2.0%. We find it very interesting that Chair Powell admitted to that today with full transparency. The implications of this are significant. Markets generally anchor to the FOMC’s guidance unless that guidance seems capricious, arbitrary and/or unrealistic. As long as the FOMC, or any central bank for that matter, has credibility then markets will generally discount what the central bank conveys. In today’s press conference, Chair Powell conveyed deep uncertainty for how high they need to hike. This moderates the weight of the “anchor” from FOMC guidance for the peak interest rate and instead may provoke the market to further discount its own expectations. We do not envision interest rate volatility will come down so long as uncertainty remains elevated for how high the FOMC must hike rates to get inflation under control. This uncertainty is problematic for risk assets.

Higher for Longer? Defensive for Longer

We continue to view the trajectory for the economy over the next 12 months through the lens of three scenarios:

1. Recession (the FOMC has tightened enough);
2. slowing growth but delayed recession (further tightening required); or
3. soft landing (inflation was mostly a supply side phenomenon and comes back down to 2.0% “on its own”).

We think the soft landing scenario is highly unlikely given our view that inflation is primarily a demand-side issue at this point and historical precedent for what is required to slow demand-driven inflation suggests a much higher unemployment rate. We think both options 1 and 2 are the most likely outcome in the next 12 months. Option 1 (Recession) is very bad for risk assets like equities and credit, and option 2 (further tightening required) is also very bad for risk assets as real rates would need to rise further. We therefore remain underweight equities and credit in our portfolios, overweight stable and low valuation businesses within equities, and overweight high quality fixed income with moderate duration.

For more information, please access our website or contact us.

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Important Information

The views expressed herein are those of Harbor Capital Advisors, Inc. investment professionals at the time the comments were made. They may not be reflective of their current opinions, are subject to change without prior notice, and should not be considered investment advice. The information provided in this presentation is for informational purposes only.

This material does not constitute investment advice and should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy.

Investing entails risks and there can be no assurance that any investment will achieve profits or avoid incurring losses.

Harbor Capital Advisors, Inc.

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