Markets

Plow Horse Economy Breaks Into Gallop

plow-horse-gallopThe plow horse recovery isn’t up to California Chrome speed yet, but it is definitely accelerating. Despite a first quarter slowdown, the recent economic data and Federal Reserve statement both point to more growth in the next year or two.

You can safely ignore these indicators most months. Trends over time are much more important than any single data point. Even economists sometimes call the short-term numbers “statistical noise.” On the other hand, when the person who hears only noise is also the Federal Reserve chair, we should probably pay attention.

Janet Yellen’s comments last week show the Fed is remarkably unconcerned about inflation. Here is what she said:

“I think recent readings on, for example, the CPI index have been a bit on the high side, but I think the data that we’re seeing is noisy. I think it’s important to remember that broadly speaking, inflation is evolving in line with the committee’s expectations.”

Yellen said this the same week as the Core Consumer Price Index made its biggest monthly jump since mid-2011. Inflation as measured by the Consumer Price Index is already at the Fed’s 2% annual target, but the Fed apparently believes the economy can bounce back from a rough first quarter without unacceptable inflation risk.

This tells us something important. Yellen and her fellow Fed governors are in no hurry to raise interest rates or otherwise tighten monetary policy. They seem far more concerned about reducing unemployment than heading off inflation, even though their statutory mandate is to do both.

Inflation-cartoon

If inflation goes higher than expected, asset prices will likely go higher than expected, too – especially stocks. The Fed is setting up a situation that will help markets over the 12-24 months, but at the risk of falling behind the curve. They may have to raise rates uncomfortably fast if inflation picks up.

Yellen’s comments suggest she watches wage pressure as an indicator. She seems to believe that the large number of long-term unemployed people will let businesses expand without having to compete for talent.

I think Yellen may be too optimistic on that last point, but it doesn’t matter for now. She is creating the conditions for another extended rally in stocks and other risk assets – and exposing bond investors to more danger than ever.

Our Republic Wealth strategy is still to overweight selected U.S. and global equity segments while minimizing interest rate exposure. Our fixed income allocations are in less rate-sensitive niches like high yield bonds. These are the trends we see, and they are the trends we will follow.

 

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