High stakes for investors as Fed tries curing inflation without causing a recession

United States

Signs of easing inflation are giving the U.S. central bank a go-ahead to do something investors have waited for all year: the first interest-rate cut since the most aggressive rate-hiking cycle of the past four decades began in March 2022.

The seemingly impossible task ahead for the Federal Reserve and Chairman Jerome Powell is to achieve a decisive victory against inflation, without pushing the world’s largest economy into a recession — or, at the very least, a deep and prolonged one.

The stakes are high for investors after U.S. stocks soared to more record closing highs over the past week. The S&P 500 SPX and Nasdaq Composite COMP respectively finished Wednesday’s session with their 37th and 27th closing highs of the year, at 5,633.91 and 18,647.45. This came after two days of congressional testimony by Powell, who seemed to move the central bank closer to cutting rates.

Powell reiterated his view that policymakers are holding a dual-edged sword: cutting rates too little or too late could undermine economic activity, but doing so by too much or too soon might damage the progress made on inflation. The Fed’s mandate is to promote full employment and stable prices.

Financial-market participants appeared to reach an inflection point in their thinking, by putting a greater emphasis on the dangers of lowering interest rates too late. The rising chance of an interest-rate cut as soon as September helped push all three major stock indexes higher for the week, though the S&P 500 and Nasdaq closed below Wednesday’s record levels.

“What’s at stake is a hard landing where we potentially see the unemployment rate go up, consumer spending decrease, more layoffs, and potentially a bear market in which there is an earnings and economic recession,” said Eric Sterner, chief investment officer at Apollon Wealth Management, which manages around $ 7.5 billion from Mount Pleasant, S.C. An earnings recession refers to a decline in corporate profits on an annual basis over two consecutive quarters.

Nonetheless, “my base case is for a soft landing because small- and large-cap companies are looking optimistic about earnings for this year and next,” Sterner said via phone. He added that all 11 sectors of the S&P 500 could produce positive earnings growth in the fourth quarter, which has not happened since 2021.

The mid-1990s cycle of Fed rate hikes followed by cuts offers a blueprint for how Powell might be able to pull off the hard trick of navigating a soft landing, even as some strategists express worry about the extent of any downturn.

Read: Stocks will fall 30% as the U.S. economy heads for a painful recession, strategist says

In 1994, under then-Chairman Alan Greenspan, the Fed hiked interest rates by 2.5 percentage points, from 3% to 5.5%, to cool a heating labor market, keep inflation in check, and maintain an economic expansion. It was the most recent, and only, time in decades that policymakers were able to raise rates without triggering a recession, according to strategist John Velis of BNY Mellon. Meanwhile, inflation, as measured by the central bank’s preferred gauge, never rose above 2.3% during that time, according to the Fed’s regional bank in Richmond, Va. — in contrast to the current era of price gains.

After one more half-point hike in early 1995 that lifted the fed-funds rate to 6%, officials then cut rates in quarter-point increments in July 1995, December 1995, and January 1996 as insurance against any possible recession. They did this even though the S&P 500 was rallying at the time.

The economy remained in expansion mode until March 2001, a year after the dot-com bubble began to burst. It had successfully weathered more Fed rate hikes and cuts between 1997 and 2000, as well as the 1997 Asian financial crisis, turmoil in Russia the following year resulting in the ruble’s devaluation, and the collapse of a hedge fund known as Long-Term Capital Management.

Walking the line between avoiding a recession and curing inflation is “such a difficult endeavor and the odds are stacked against it, but you have to say, `so far, so good,’ and it might be possible,” said Lawrence Gillum, a Charlotte, North Carolina-based fixed-income strategist for broker-dealer LPL Financial. “You could argue that a soft landing, or immaculate disinflation, scenario is priced in. In any other scenario, be it a hard landing or economic downturn, risk assets could be in for a rude awakening.”

Interest rates have remained between 5.25% and 5.5% for the past year, long enough to start having an impact on the economy as demonstrated by lackluster GDP growth in the first quarter, downward revisions in job gains, and a cooler consumer-price reading for June. Next week’s batch of economic data includes June’s U.S. retail-sales report, released on Tuesday — which will provide clues of how well American consumers are faring.

“Right now, the risk of cutting rates too late is bigger than the risk of waiting,” Gillum said via phone. Even so, rate cuts are “absolutely” a risk for the stock market because of the possibility that they could eventually reignite inflation again. “Our view is that we still have sticky inflation and it’s going to take a while before we get back to the Fed’s 2% inflation target. I’ve been telling clients that trying to price in three rate cuts is unrealistic. We expect two this year.”

Fed-funds futures traders — who began the year expecting as many as six or seven 2024 rate cuts, only to pull back on those expectations — now see a decent chance of five or six quarter-point reductions through next June, with the first move arriving in two months. Meanwhile, one policymaker, San Francisco Fed President Mary Daly, stepped forward after Thursday’s release of the consumer-price index for last month to say that she now supports lowering interest rates.

Sterner of Apollon Wealth Management is among those who initially believed a recession would be needed to cure inflation. He said he has since changed his mind.

In his view, “what makes this cycle different from the past is that consumers have continued to spend despite high inflation, by drawing from savings built up during the Covid lockdown; fiscal stimulus has boosted government spending; and private credit funds have stepped in to provide lending that has kept mid-sized businesses going.”