Bideneconomics, The Fed and Markets

The stock market could try to stabilize this week in anticipation of a seasonally better October.  Also, a soft August Consumption/Core PCE Deflator report could help on Friday.  Although there will likely be a lot of wrenching headlines about the difficulty of passing legislation to extend the federal budget past month end, this should be accomplished at some point.  So, it's just a temporary issue.  More importantly, the macroeconomic/policy background remains problematic, as discussed below.  Clear evidence of slower economic growth is needed to open the door for a significant rally in stocks.

Market commentary on last week's FOMC outcome highlighted the implication that the funds rate will be higher for a longer period than had been projected at prior meetings.  It has not delved much into why this will be the case.  Two reasons are /1/ Bideneconomics and /2/ the inherent dynamism of the US economy.

Putting aside political considerations, Bideneconomics can be defined as using government subsidies to promote alternative energy and bringing manufacturing operations back to the US from abroad (called "reshoring").  Pushing alternative energy is based on the idea that the market doesn't reflect "externalities" in the price of oil.  The externalities include pollution and climate change.  There is also a defense rationale, as is the case for reshoring.  

From a macroeconomic perspective, all these initiatives have one important effect in common -- they create demand for labor and other resources.  This increased demand would not be a problem if the US economy had a lot of slack.  However, the economy is now essentially at full employment.  So, these initiatives lead to higher inflation if not offset by a decline in activity elsewhere in the economy.  And, that offset or "crowding out" is what the Fed tightening is trying to do.  And, when it eases up on tightening, the markets do the work.  Currently, the sharp rise in long-term Treasury yields and the strengthening of the dollar are doing most of the work. 

This situation is a double-edged sword for the stock market.  On the one hand, the Bideneconomic initiatives boost the economy, holding back a recession as the Fed tightens.  On the other hand, higher long-term yields lower the present value of future earnings.  And, a stronger dollar lowers the value of earnings from abroad. 

The second reason for expecting the funds rate to stay high for longer is the inherent dynamism of the US economy.  If the Fed and markets pause in their restraining actions, economic growth will be quick to speed up, particularly with the Bideneconomic thrust in the background.  And, inflationary pressures will reassert themselves.  This responsiveness may help explain why the US economy sped up this summer soon after the Fed downshifted its rate hikes.  It also raises doubts about the plausibility of the rate cuts envisioned by Fed officials for 2024.  The only scenario in which rate cuts would not create an inflationary problem is after a recession has pushed up the unemployment rate to a high level.  

The consensus estimate of the August PCE Deflator (+0.5% m/m Total and +0.2% Core) looks reasonable.  Airfares should not rise as much as in the CPI, since their smaller increase in the PPI is also used in the PCE Deflator.  And, Owners' Equivalent Rent has a smaller weight in the PCE Deflator than in the CPI.  The consensus estimate of August Consumer Spending (+0.5% m/m) translates into flat Real Consumption for the month.  It is premature to conclude that the consumer is weakening, however, since a flat August print could be just the typical pause after a strong month (July).  Unemployment Claims data still show strengthening demand for labor in September.