FOMC Recap: It's a Vibe

IT'S A VIBE

• As expected, the FOMC is on hold for the second straight meeting, leaving the Fed Funds target range at 5.25% to 5.50% and leaving QT unchanged
• The Fed remains committed to returning inflation to its 2 percent target
• Powell is not confident yet that rates are sufficiently restrictive to bring inflation back to 2%, not thinking about rate cuts
• The rise in long-term yields has been viewed as being driven by exogenous factors that should slow the economy and effectively do the job of additional rate hikes as long as there is a persistence of these higher yields

About a week ago, a few days after BEA data shows the U.S. economy grew at 4.9% in the 3Q2023, I was awakened to the text message above, a text which is emblematic of how it seems many people feel about the state of the U.S. economy. While statistically the U.S. economy is by all accounts in pretty good shape, with current low unemployment, strong GDP, household net worth at record levels, and slowing inflation, the overall sentiment seems to be pretty bad.  The recession calls of the past 18 months continue to plague the psyche, the recent geopolitical actions have reminded us that the world is indeed a scary place, there are economic concerns tied to the government financing, commercial real estate, regional banks, China's economy and the list goes on.  

The term "vibecession" was reportedly coined by Bloomberg Opinion contributor Kyla Scanlon to describe such a situation where sentiment risks creating narratives that actually lead to consumer and business behavior that does in fact lead to a decline in real economic activity.  In my opinion this is "vibecession" thinking is a form of Keynes "animal spirits" .  Post-Keynesian economist would probably say we should be fairly concerned about the bad vibes.

How much expectations matter for inflation and central bank policy is a source of debate, but with nominal GDP growth sporting an 8 handle, it might be hard to see an immediate impact from sentiment.  Nonetheless, I believe the Fed is cognizant of the "vibes" as they continue to assess the cumulative impact of rate hikes to date, the potential lagged impacts and the uncertain impact of policy on financial conditions.

In my opinion, the text message above and the term "vibecession" are really problems in risk management and dealing with uncertainty.  The Fed is also dealing with this risk management problem and inherent uncertainty when asking "should we hike more?"  While Powell believes the risks are more two-sided at present, he noted that there are risks that policy may not be sufficiently restrictive even with uncertainty over the impact of lags.

I'm not an expert on Keynes, but Robert Skidelsky is one such expert.  In his book "What's Wrong With Economics?"  he spends some time discussing Keynes perspective on risk and the differences between risk and uncertainty.

"risk refers to all outcomes that can be insured against, uncertainty to those which cannot."

" ..uncertainty as both Keynes and Knight define it, but which the mainstream denies: a situation where we have no scientific basis for calculating a ratio (probability)."

Effectively, Keynes (as reported by Skidelsky), defined risk and uncertainty as being on a continuum: "The magnitudes of some pairs of probabilities we shall be able to compare numerically [cardinal probabilities], others in respect of more or less only (i.e. 'more or less likely', "ordinal probabilities), and others not at all [uncertainty]." 

Fortunately one of the great triumphs of Finance is that it gives us ways to manage risk through innovations such as insurance and hedging. Unfortunately, it cannot eliminate all uncertainty, and of course taking some level of risk is necessary to meet return objectives.  

A prudent way to navigate the inherent uncertainty in the world and economy is by maintaining some flexibility, a buffer, a margin of safety and a level of creativity in planning.  This flexibility isn't free, it's the extra turn of leverage not taken, it's the liquidity not deployed, or other analogous things, but it also provides a valuable option to change course when things aren't working out.  It creates a condition to increase the odds of survival and survival is what allows individuals and businesses to adhere to Charlie Munger's first rule of compounding: "The first rule of compounding is to never interrupt it unnecessarily". Perhaps this is why the Commercial Real Estate industry has clung to the motto "survive to '25".

Just the other day economist Brad DeLong shared a substack post which discussed the long-run outperformance of U.S. equities over U.S. government bonds.  After reviewing the data, which shows the 65004-to-41 wealth gap in favor of stock investors since 1870, he posits: "But if stocks are such a good deal for the long run, why are our investors in the stock market not richer?" to which he retorts: "there is a reason why they are not even richer. It takes time for the law of averages to work itself out. And "average" is only "typical" if you have that time. If you lose your stake and cannot continue to play, you do not have that time. Mathematically, your strategy may have had a high expected return. But the typical investor who undertakes that strategy never sees that expectation."

It is unfortunate that the ideas of market efficiency and staying the course seem to be fighting an uphill battle of late. After all, if we all thought there was certainty that a financial crisis was right around the corner, we would all act on that information today and in essence we would cause that crisis today.  In theory all of this negative sentiment, and the beliefs about fiscal and monetary reaction functions are already "priced in" to today's markets   We also generally know that investors who try to time the market fail, or even if they can get out at the right time (top), they fail at redeploying their capital when the market truly does look cheap (even based on whatever metrics led them to sell in the first place). Perhaps the reason these ideas sometimes fall by the wayside is that people find it much more interesting to read a post about recession or doomsday than to read a post about risk management.

Back to the Fed, can the Fed engineer a "soft landing", can they get inflation back to 2% without pain? I don't know.  In my last FOMC recap, I described what I see as the three main "endings" to the current rate hike cycle that I see most commonly discussed in financial media, these are broadly (1) soft landing, (2) financial repression or (3) hard landing.

I don't know how the economy will unfold from here, or what other "shock" will hit in the interim, but I think that I know that surviving through whatever downside scenarios you can imagine will allow you to most fully maximize returns in the long run.