Another Major Fed Policy Error

The Fed raised rates today despite overwhelming evidence that inflation is rapidly cooling.  Specifically, CPI core has declined by .5% over the last 4 months to only 2.4% and over the last 4 months annualized inflation is only 1.8%. CPI Y/Y is only 2.1% excluding airline fares, which are almost exclusively driven by rising energy prices.  The Fed fails to recognize that PCE core has become highly distorted by imputed estimates of portfolio management and software inflation that have changed the historical relationship of PCE, which has historically averaged 40bp below CPI core.  In addition, both CPI and PCE are overstated by the deeply delayed shelter component of inflation.  If real time market data were used to calculate CPI Core, it would be only 1.2% Y/Y and PCE Core would be only 2% (see infracapfunds.com).

The Fed’s hawkish policy stance has driven the 10-year to almost 5% which has driven the 30-year mortgage to well over 7%.  The housing sector is already in a mild recession, but the recent rise in rates is likely to put it into a deep recession.  This will cause GDP growth to drop below 2% despite the tailwind from AI investment.  The rate increase will do nothing to slow inflation as the interest rate sensitive sectors of the are already in decline and market rents are negative.  Today’s situation is the exact opposite situation from early 2021 where the policy rate was zero and housing inflation was running over 20%, making the need for a rate increase imperative.

We are lowering our S&P 500 Index price target from 8,300 to 8,000 as the 10-year at 5% implies an S&P multiple of 19x vs. our prior multiple of 20x.  We actually started the year with an 8,000-target based on 23x 2027 and a 10-year at 4%.  Since that time S&P estimates have risen 18% supporting the market in the face of much higher interest rates.  Every 25bp of 10-year yield change impacts the theoretical PE multiple by one point.

The Fed’s deeply flawed policy framework led it to make yet another major policy error.  The Fed’s policy framework is fatally flawed due to the fact that 1) It follows the massively distorted PCE price index 2) Its inflation forecasting model is completely broken as it ignores money supply growth and follows the failed Phillip’s Curve inflation model and 3) It follows an inflation target that  is completely arbitrary and empirically too low.  It is imperative that the Fed’s policy framework is reformed and we are hopeful that the Warsh task forces will make significant changes that avoids policy mistakes like today’s or the “transitory” debacle.