Zacks Investment Management

In today’s Steady Investor, we dive into key factors that we believe could impact the future of the market such as:

• The Federal Reserve Holds Rates Steady
• Oil Prices Pose Another Potential Problem for the Fed
• Can the Federal Reserve Manage a ‘Soft Economic Landing?

The Federal Reserve Holds Rates Steady – On Thursday, the Federal Reserve voted to hold the benchmark fed funds rate steady at a range between 5.25% and 5.5%, which aligned with the market’s expectations. The decision was not without surprises, however. Chairman Jerome Powell signaled again that rates could wind up being ‘higher-for-longer,’ and there were hints that some Fed officials believed the neutral rate – which is a rate at which inflation and employment can remain stable and mostly in balance – has arguably moved higher, too. Prior to the 2008 Global Financial Crisis, the neutral rate was largely thought to be somewhere in the 4% to 5% range, which after subtracting 2% inflation would place the real neutral rate around 2.5%. In the decade following the crisis when the Fed pushed rates down the zero bound, the economy only grew modestly while inflation was never much of a threat. In this time, estimates for the neutral rate began to fall, scaling down to 2.5% by 2019. Fed officials are clearly starting to think about the neutral rate differently now, with the U.S. economy not only withstanding a fed funds rate of 5.25% and 5.5%, but also growing firmly. This has reset market expectations for where interest rates could go from here, particularly as inflation trends lower but still has some ways to go to reach 2%.¹

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Oil Prices Pose Another Potential Problem for the Fed – the third quarter has seen a virtually straight-line rise in oil prices, charting a roughly 25% increase in the price of a barrel of Brent crude.³

Supply and demand forces are at work. On the supply side, Saudi Arabia and Russia’s announcements to curb production until the end of the year have been a major driver of the rally, but demand from better-than-expected U.S. and global economic strength has also kept upward pressure on prices. Oil’s ascent to nearly $100 a barrel poses problems for corporations, consumers, and the Federal Reserve. Higher fuel prices eat into profits for companies, while consumers’ discretionary income feels a pinch from higher prices at the pump. While the Fed concerns itself mostly with “core” inflation, which strips out food and energy, the knock-on effects of higher fuel prices can show up elsewhere in the economy. This means that although the Federal Reserve tries to focus on underlying inflation forces, higher energy prices could ultimately play a role in interest rate policy in the months and quarters ahead.

Can the Federal Reserve Manage a ‘Soft Economic Landing?’ – History suggests the answer is no. Prior to the 1990, 2001, and 2007 recessions, many economists believed that the Federal Reserve had managed to engineer a soft landing, with interest rate increases effectively stemming inflation while not leading to an economic downturn. Instead, the economy entered a recession each time. A key issue with achieving a soft landing is that once the economy goes from being overheated to largely in balance with regards to inflation and employment, any factor that pushes demand higher or lower could knock inflation higher or employment lower, respectively. The most recent example of a successful economic soft landing came in 1995, when Fed officials had doubled the fed funds rate quickly from 3% to 6%, but realized quickly that they were too aggressive – which immediately led to three rate cuts. The central bank generally does not want to be seen as indecisive, which makes cutting rates shortly after hikes one of the least desired outcomes.⁵ The Fed vice chair from 1994 to 1996, Alan Blinder, said of the soft landing that “We steered the economy very expertly, but in addition, we were lucky. Nothing bad happened.”

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