Fed action is staving off inflation to prolong long-term economic growth

If one believes the Fed is raising rates in reaction to early signs of inflation, the Fed should continue to raise rates to prevent a potential overheating.  Recent regional surveys mention labor market tightness in regions such as Boston, Philadelphia, Cleveland, St. Louis, Kansas City and San Francisco.  Goldman Sachs economist Jan Hatzius believes current unemployment levels are already below a natural unemployment rate of 4.5%. 

Interest rates remain well below historical levels, which leaves it little room to react to signs of economic weakness. 

Raising rates could be viewed as necessary to rearm the Fed’s arsenal.  The ‘economy too hot but controllable’ scenario would argue for investors to stay in domestic equity stocks and enjoy the longest bull market in history.  Banking stocks would also benefit from further interest rate increases.

The Fed is being overly cautious and that could reign in the economy

If the Fed is being overly cautious, it is reasonable to think the interest rate increase could not only slow the economy but put it back into a recession.

The lower end of the yield curve inverted on December 4th.  According to Kim Amadeo, the Treasury yield curve inverted before the recessions of 2000, 1991 and 1981.  If the economy were to slip into a recession, the Fed would be hard pressed to prevent a quick drop. 

Narayana Kocherlakota questions the effectiveness of interest rate changes to spur the economy and argues, “that the economy should be as strong as possible when the downturn hits.”

Absent a move by the Fed to bolster the economy now, investors would be wise to move money into the bond market, utility stocks, or maybe even foreign markets.

The Fed is towing the line between growth & inflation while watching international developments

Perhaps a third scenario exists.  One where the Fed is not that worried about inflation but concerned about the impact of a protectionist approach to trade or rising national debt levels following the cut in tax rates. 

Decreased trade could lead to both inflationary pressure through the form of higher input pricing and recessionary pressure through the form of decreased economic output.  

Former chairman Alan Greenspan warns about the possibility of a period of stagflation with both high inflation and unemployment.  Some pundits, such as Ben Levisohn, believe the Fed is in a no-win situation.  Levisohn said that If they raise rates further, the market will react negatively because it will slow the economy; but if they stop raising rates, the market may view that as a sign of a weakening economy and decline anyways. 

Under such a scenario, investors are left monitoring political news and reacting to daily changes in policy to decide where to make investments.  And, uncertainty is every investor’s worse fear.

Sources:

“The Beige Book” Federal Reserve District, Jan. 17, 2018

“Goldman Sachs: The economy needs to slow down to avoid a ‘dangerous overheating’   Jeff Cox, CNBC Nov. 5, 2018

"Wages and Transport Inflation Is Here: How Retailers Can Cushion the Blows” Michelle Lodge, The Street May 19, 2018

"Inverted Yield Curve and Why It Predicts a Recession” Kimberly Amadeo, The Balance Dec. 5, 2018

“The Fed Should Prepare for the Unexpected” Narayana Kocherlakota, Bloomberg Aug. 29 201

“The Fed is worried about a trade war” Donna Borak, CNN Business July 5 2018

“The Market Wants the Fed to Stop Raising Rates. That Might Not Be Good for Stocks” Ben Levisohn, Barron’s Dec. 18 2018

“Alan Greenspan: Investors should prepare for the worst” Donna Borak, CNN Business Dec. 18 2018