The Fed took the market at least a little bit by surprise when it decided to project two more rate hikes earlier this month. It comes as readings on consumer prices continue to slow, and as the Fed itself admits that the impact from past increases have yet to be felt on the broader economy.
Tom Essaye, the founder and president of Sevens Report Research, says the answer to this puzzle lies in a framework put out by former Fed Chair Ben Bernanke, in a paper published in May.
Bernanke, and co-author Olivier Blanchard, say that wage inflation was only responsible for a small part of the surge in inflation, as they put greater emphasis on supply shocks.
As Essaye puts it:
Bernanke’s paper demonstrated that supply driven inflation shocks (where the supply chain causes it) usually reverse the gains over time. To understand this point, just look at retailers such as Target and others. Inventories plummeted during the pandemic as global supply chains froze and prices spiked. In response, stores over ordered to try and get merchandise. But as supply chains normalized, they were flooded with inventory which they had to heavily discount to move. It’s essentially why large retailers such as Target have struggled over the past year (and why stores like Bed Bath & Beyond went out of business). In the end, the supply side price shock was temporary and largely went away.
That sounds like good news for the Fed, right? But the Bernanke paper also warned that the longer a tight labor market is allowed to persist, the greater the chances it becomes a constant source of upward inflation. “If the current Fed is listening to Bernanke (and I imagine they are), then the Fed may be more focused on unemployment than anyone appreciates,” says Essaye.
That’s why there is 50 more basis points of hiking in store, probably regardless if CPI declines further. Essaye says the focus will be on the labor market, and markets have two fears — either no change, which will mean the Fed will have to get even more hawkish, or a really sudden deterioration, in which case there will be evidence it’s gone too far.
He says a “growth-on” basket of ETFs would include the equal-weight S&P 500
RSP,
and sector funds covering energy
XLE,
industrials
XLI,
and materials
XLB,
— which have rallied in June because of soft landing hopes. But he expects defensive sectors will outperform over the medium term as the economy slows, as they have the last three downturns.
This story originally appeared on Marketwatch
