Time to Retire a Cycle
Time looks ready to expire on the elevated short-term interest rates that investors have enjoyed over the past few years. For far longer than most probably expected, the Federal Reserve maintained restrictive interest rate policies on the economy to drive inflation out. The Federal Reserve's restrictive policies that introduced higher interest rates to the markets benefited Investors without much economic damage. But, the current interest rate policy and cycle won't last forever because it can eventually turn counterproductive to economic growth and employment.
A conventional expectation among investors is that it takes six to twelve months before a change in economic policy affects consumers and businesses. The duration of the current monetary policy or cycle has gone on for far longer than most investors probably expected when the Federal Reserve first increased interest rates thirty months ago in March 2022. As a result, many thought an economic recession would have occurred by now, and the Federal Reserve would have reduced interest rates in response to economic weakness. Neither has happened yet.
The unemployment rate is a carefully watched number by investors due to the tight connection between labor markets and the economy. Investors treat unemployment as a lagged indicator that adjusts slowly after economic cycles change. Maybe now, after an exceptionally long lag, the unemployment rate has started to respond to the Federal Reserve's elevated interest rate policy. The unemployment rate has risen nearly a full percentage point recently from the record lows it obtained after the pandemic ended. Currently, there are about seven million unemployed and eight million vacant jobs. So, that's slightly over one available job for every unemployed person, which is a significant change compared to a year ago when the ratio was closer to two jobs for every unemployed.
Recent trends in the labor market may have started to show the impact that higher interest rates have had on the economy. In response, investors feel almost certain the Federal Reserve will make its first interest rate reduction at the next meeting scheduled in September. In addition, investors seem highly confident that ultra-short-term interest rates could be a full percentage point lower by year-end. Some investors believe the economy needs these significant interest rate reductions immediately if the Federal Reserve intends to keep this economy out of recession. The Federal Reserve will likely move its policy rate closer to where investors have priced market rates to avoid frictions in the financial system.
Based on past cycles, economic activity has traditionally performed well when the Federal Reserve maintained policy rates near the nominal expenditure growth rate observed economically. A good model for nominal expenditures is the economy's gross domestic product because it includes a price component and a real growth rate. The average annualized US GDP rate in the second quarter of this year conveniently approximates where the Federal Reserve has placed its policy rates. However, given that inflation rates have declined recently and unemployment has risen, interest rate policy at the Federal Reserve could fall behind where the economy currently stands. That could be a bad look for the Federal Reserve, which it likely hopes to avoid, and another reason why it may begin to decrease rates soon.
As investors, it's important to be open to change because it's inevitable, and markets embrace change constantly. Examples include the economy and stock market, which have experienced significant changes over time regarding diversity in industries, sectors, and geographic exposures. This diversification creates opportunities for investors. Similarly, the transitioning monetary policy cycle also presents opportunities for investors to reassess risk, review their financial goals, and implement any applicable portfolio changes.
