Will the Fed encourage or discourage growth?

by John Manley, CFA, Wells Fargo Asset Management

“Man is the measure of all things.” Protagoras

I have been told that this quote should really read “Man is the measurer of all things.” If this is true, then Protagoras would feel right at home on Wall Street today.

When it comes to the stock market and the economy, everything is measured; everything is weighed; everything is compared. Patterns are discerned and then projected forward. The data are prolific and their manipulation is quite thorough. We know what months have been best or worst for the stock market (unless, like in 2016, the market hasn’t been following its usual pattern). We can take numbers and turn them into concepts, turn those concepts into Greek letters, and then create subtle and persuasive models. In short, we know most of what there is to know about momentum, valuation, and profitability in stocks.

But do we really know what all of this means for tomorrow? I think our numbers only take us part of the way there.

The context behind the Fed’s next move

The numbers are only the starting point. They tell us what is and what has been, but without a little searching, they won’t tell us “how” or “why.” To get from the past to the future, we must come through the present, and we must understand why past events evolved as they did.

This point seems particularly important today as the capital markets struggle to come to terms with the Federal Reserve’s (Fed’s) next rate hike. We know the history of the Fed: what it has done and when. I can find the average time between the last rate cut and the first rate hike. I can discover the patterns of subsequent hikes and, again, discern and “average.” But these things don’t tell me what’s going to happen next time. They say that you can drown in a lake that has an average depth of two feet. The average may be all well and good, but we should try to figure out what we are stepping into.

That involves asking why the Fed does what it does.

The Fed’s stated purpose may be to maximize growth while minimizing inflation. But, in practical terms, that means moderating economic growth. The problem is that the Fed lacks the tools to do this directly. It can’t order us to buy cars, build houses, or open factories. It really can’t order us not to, either. All it can do is make the money we’d use to do those things seem cheap or expensive. That means pushing money into the economy when it is too slow and pulling money out when it’s growing too fast. We in the equities business are affected by these processes, because that money in motion flows through us on its way to its final destination.

To me, this means that it is inadequate—if not fruitless—to speculate when and how many times rates will rise. If the Fed can’t seem to agree on that, how are we to know? The better and more useful question is far simpler: in the next 12 months, will the Fed try to encourage or discourage economic growth?

If the Fed’s goal is to stimulate growth, then the interest rate it chooses will reflect that. The Fed will only raise rates to levels that will not suppress growth. A stronger economy can afford to pay higher rates for its money than a weaker economy can. Consider mortgage rates for first-time homebuyers. In one economic environment, a 2% rate could be restrictive—while in another, a 6% rate might have been quite stimulative. The nominal rate must be viewed in the context in which it exists.

I may be wrong, but I simply can’t imagine the Fed purposefully discouraging growth. If the facts change, I will change my mind, but, for now, I expect money to continue flowing in the direction of the stock market. I will let someone else figure out the numbers on that.

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