More on the Gap Between Expectations and Reality
On Tuesday investors were shocked - shocked - that inflation came in higher than expected. They shouldn't have been.
I've been explaining that nothing in finance or economics moves in a straight line, despite our propensity for extrapolating in that fashion. Inflation may eventually reach the Fed's 2% target, but it was unrealistic to expect that to happen immediately (I don't think it's likely to happen anytime soon, for that matter, but that's a subject for another letter).
Even after the market sell-off in reaction to this week's inflation number, investors are still overly optimistic because they're still overly simplistic. It's not as if Fed Chairman Powell and his Fed Governors have complete control over the economy and inflation. There are dozens of variables that affect inflation. Some the Fed can directly influence and others they have little control over. Some can be quickly reversed and others can't.
Inflation is likely to be more volatile than investors are expecting, or than has been priced into the market. The Fed may eventually stick their 2% target, but it won't happen overnight. Inflation will probably bounce around for a while, and investors might continue to find that unnerving.
Another investor miscalculation continues to be how aggressively the Fed is likely to cut rates. I've already pointed out the disconnect between market expectations for future cuts and what Powell is clearly stating.
The Federal Reserve is unlikely to make as many interest rate cuts, or cuts as deep, as investors are pricing in. There's no reason to do so. With the economy continuing to hum along, why risk stoking inflation unnecessarily? Just last month, investors were pricing in an 80% likelihood of a March rate cut.. I couldn't figure out why investors were ignoring what they were being told by Powell and others at the Fed. That's now a 10% likelihood. Even today, if you're anticipating major easing, you should be asking yourself why. I'm not saying that a recession is imminent, but the only reason for the Federal reserve to substantially cut rates would be to combat a weak economy, and I don't understand why investors think that would be good for the stock market.
What moves markets in the short-term is the gap between expectations and reality. I believe it's likely that expectations today aren't fully factoring in the reality on the ground.
David Harris, CIMA