Monetary Policy as a Balancing Act

The Federal Reserve faces the challenging task of bringing inflation back to its target level of 2% while simultaneously stabilizing economic growth. Recent macroeconomic data suggest that a change in interest rate policy is imminent.

In the aftermath of the pandemic, the Federal Reserve faced the highest inflation since the early 80s. In response, interest rates were rapidly raised from 0% to 5.5%. The unprecedented tightening of monetary policy slowed the strong economic growth that was triggered by government stimulus and pandemic-related catch-up effects, bringing inflation under control. In the past, an economic "soft landing," where the central bank tightens monetary policy without triggering a recession, was successfully achieved only once in the 90s. Thus, market participants are trying to assess whether a “soft landing” can be accomplished in the current market environment.

Examining the data from the past few months reveals that, after minimal progress at the beginning of the year, inflation has now steadily declined over the last three months. US consumer prices for June once again printed below economists' expectations. The significant drop in shelter costs, which had previously proven to be very persistent and a strong driver of core inflation, was particularly well received. Examining the U.S. labor market, recently released data shows a slowdown in job creation. Furthermore, wage growth seems to be moderating. The unemployment rate rose to 4.1%, the highest level in more than two and a half years, already reaching the Fed's forecast for the end of 2024.

Overall, economic momentum is slightly weakening. The leading US purchasing managers' indices printed weaker than expected, with both the manufacturing and services sectors falling below the neutral value of 50. Additionally, there has been an increase in delinquencies on credit card debt, and the savings of US households, apart from the very wealthy ones, are largely depleted.

In summary, current economic data suggest that the Fed is likely to soon increase its focus on its second mandate — promoting maximum employment — alongside its dual mandate of price stability. Interest rate forwards also reflect these expectations and now anticipate that the Fed will cut interest rates by 0.25% in September, followed by at least one more cut in November or December. Overall, confidence in a soft landing of the economy is growing in the stock market. More cyclical and interest rate-sensitive equity sectors have significantly outperformed since the release of the latest inflation data while previously dominant technology stocks have underperformed. Small caps, which have been totally out of favor by investors, jumped by more than 10% in only 5 days, with banks and real estate companies also gaining.

Equity prices already reflect significant investor optimism, resulting in elevated valuations and high expectations for future earnings growth. Therefore, we maintain our neutral stance towards equities and focus on high-quality companies with solid balance sheets that can perform well even during periods of slowing economic growth. Achieving a soft landing seems within reach, but history also shows that the likelihood of external shocks increases the longer rates stay high.