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The Fed's Gymnastics:  Can They Nail the Landing?

The Fed's Gymnastics: Can They Nail the Landing?

| December 19, 2022
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As we close out 2022, the tug-of-war between inflation indicators and "Fed Speak" continues to occupy investors attention.  Again, investor optimism has given way to caution as broadly improving inflationary trends have met a hawkish Fed that is committed to killing inflation in its tracks.

Investors are rightly worried that the Fed will kill more than inflation.

As we have previously written, so-called "headline" inflation typically refers to price levels versus the same period last year.  You might say, "Surely the Fed is looking through that number to see shorter term trends?"  I hope that they are, but their comments often indicate they they are not -- especially when looking at wage inflation.

Raising interest rates surely isn't the easiest way to restore balance to the labor market -- especially one that has been materially affected by a pandemic. For instance, the Brookings Institution estimates that between two and four million workers may be out of the labor force due to illness, retirement or death stemming from COVID or long COVID Symptoms.1  This is a $100bn+ annual drag on the US economy.  One can't fix this with higher rates, and in fact, it might be counterproductive.

The Fed is correct, however, in believing that psychology matters.  Their work to raise the risk of recession does send a cautionary signal to workers that retaining employment might outweigh higher wages and benefits for a time.  But it's a risky gambit to use slow-acting tools (such as interest rate changes, whose affects won't be fully felt for months) to engineer a "soft landing" for the economy.

So, investors are left trying to guess:  Can they nail the landing?

This uncertainty over the Fed's gymnastics has met the seasonal trend of tax-loss harvesting. For those unfamiliar, "tax-loss" trading refers to the practice of investors managing their future tax liabilities by selling holdings at a loss to offset gains taken earlier in the year.  

The wave of tax loss trades varies in intensity from year to year, but in a year such as 2022 when investors are nursing losses, it is a bit of an insult having to pay a tax on gains while staring at losses.  Experience has shown that seasonal patterns can exacerbate trends already underway, accelerating a year-end decline.  We think this is happening now.

2023 is shaping up to be more of the same battle until it becomes clear that the Fed has put inflation in its rear view mirror.  Investors might then be able to ascertain the shape of the economy and earnings allowing them to properly place a value on stocks without the discount that today's uncertainties demand.  


1 https://www.brookings.edu/research/new-data-shows-long-covid-is-keeping-as-many-as-4-million-people-out-of-work/

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