Parsing Through The Inflation And Interest Rate Debate

Telemus Weekly Market Review August 21st - August 25th, 2023

A primary debate in the markets remains inflation, notably its cadence and how price changes may influence the Federal Reserve. On Friday, Federal Reserve Chairman Jerome Powell spoke at an annual central bankers’ conference and emphasized that inflation still isn’t where the Fed would like it and they will do what is necessary to get it back to 2%. 

Comfort should be taken in the fact that inflation has gone from over 9% in June of last year, to 3.2% over the past twelve months. Gasoline prices are down considerably, and grocery bills are no longer spiking. Moreover, annual apartment rental rates, which were up double digits in late 2021 and 2022, have moderated and are back in line with historical norms. However, the current inflation rate of 3.2% is viewed as too high and getting the last one-percent reduction is likely to be the hardest piece to achieve. 

The challenge in forecasting inflation is that there are a lot of moving pieces. For example, oil and gasoline prices have been shooting higher in the past month. Strong demand for gasoline has led to lower inventories and consequentially higher prices at the pump. In and of itself, this will likely lead to a higher Consumer Price Index reading for the month of August. But we know gas prices move up and down and it’s unclear as to whether we are facing the start of a new rising price trend for gasoline. Alternatively, prices of grains have more recently experienced larger price moves (both and up and down) as dry conditions in the early part of the summer have been resolved with a wetter second half. Shelter costs have been moderating. However, there is expected to be an outsized number of new apartments completed in the second half of 2023, which could weigh on rental prices in the short-term. The new supply of apartments, however, is concentrated in specific geographies and may not have as great of an impact nationally. 

The discussion around these moving pieces goes to show there is frankly a lot of short-term factors that are outside the control of the Federal Reserve. The Fed and its policies can help to moderate demand in aggregate across the economy, but their blunt tools can’t directly impact pieces such as gasoline prices or the cost of corn. Weather patterns, drilling activities, and even geopolitical influences all have an impact. 

Our baseline expectation is that the current interest rate policy set by the Fed should remain near current levels for an extended period that will likely span well into 2024 if not even 2025. We also recognize the possibility exists for some small rate hikes should the Fed remain uneasy that the path of inflation remains too high. However, the pressures on the banking system that were highlighted by the failure of Silicon Valley Bank are likely to keep the Fed from enacting any significant hikes in the near term. We expect some level of volatility to remain in the bond market as incremental data points are parsed through

Our practical approach to managing through this environment is to first recognize that inflation will have a bit of two steps forward, one step back cadence to it. We don’t want to overreact to any one monthly reading. Second, predicting interest rates is something we haven’t seen anyone do with success on a consistent basis. Therefore, one should invest with a multi-year perspective on interest rates, not a view on what rates may do over the next month or quarter. Over a multi-year horizon, we view bonds as being reasonably attractive given they presently offer mid-single digit yields, an attractive level relative to what investors have been able to garner over the past fifteen years.  

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