Episode 30 – Parsing the Fed

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Welcome to Market Perspectives, a Mercer Advisors podcast. Today’s episode, we’re going to be parsing the Fed. I’m Josh Zumburn and I’m the Director of External Communications here at Mercer Advisors. I’m joined today by Don Calcagni, our Chief Investment Officer. Don, thanks so much for being here.

Hi, Josh. Thank you so much. It’s great to be here again.

So on September 17, the Fed cut interest rates for the first time this year. They cut their target interest rate by a quarter of a percentage point and signaled they might cut two more times before the end of 2025. Now, this particular Fed meeting has drawn out-sized attention because it’s the first cut in a while.

But because there’s been a political uproar about the Fed, right? The President’s been pressuring the Fed to lower interest rates. That’s part of the context here. But we want to talk about I think, the state of the U.S. economy right now and ask the question, really, what are the implications for us as investors for an interest rate cut right now.

And so Don, let’s start this look at the economy through the Fed’s eyes. The Fed, and this is actually part of the law that governs the Fed, right? Has a dual mandate. Explain to our listeners what the dual mandate is what the Fed means by that.

Yeah, so the Federal Reserve Bank, which was originally established in 1913, to manage inflation, to manage the country’s economy more broadly. But in 1978, there was a law passed by Congress that effectively put in place a dual mandate for the U.S. Federal Reserve bank. So there’s two pieces to it. The first piece is stable prices. We don’t want runaway inflation. We want stable prices. And the second mandate is that we want maximum employment.

Now, these are two mandates that to a large degree are in conflict. If you want stable prices. You need to be very hawkish on inflation that may require, and often does require, that the Fed raise interest rates to make it more expensive for businesses and consumers to borrow. And if it’s more expensive for us to borrow, the logic follows. There’s less cash being pumped into the economy, and that starts to cool off the increase in prices. That’s inflation.

Now, that also tends to hurt job growth. It tends to hurt job creation, things like that. So we also want maximum employment. We want jobs.

We need jobs. And so these two things are often a bit in conflict. There’s a little bit of tension between the two. If you cut interest rates, you pump more cash into the economy.

Arguably you could create more jobs, but that effectively, Josh, that is the dual mandate. The Fed is trying to do those two things.

And if you think about those two things, every single economic data point ultimately influences one or both of those two things. Everything from GDP growth, to tariff policy, to immigration policy. All of those things ultimately impact whether or not the Fed is going to be successful in achieving their dual mandate.

And when Fed officials talk about their policy, it’s almost always in this context. They’re always talking about what the economy looks like relative to these goals. It’s not how everybody out there as an investor thinks about it, but it’s how the Fed very much thinks about it.

And so, let’s look at these two pieces of the mandate, the way the Fed might look at it. So, let’s look at inflation first. I mean, obviously if we look over the past 5 years, we’ve lived through a period of considerable inflation. We haven’t had stable prices. But I think the question is, where are we right now this summer in 2025?

Yeah, I mean, correct. I mean, as you rightly point out, over the last several years, we have had a bout of very painful inflation, the highest inflation since about 1980. And coming into the year, that inflation rate again, the rate of growth in prices came down. But prices, let’s be very clear with our listeners, prices were still continuing to rise. And even as of today, prices continue to rise. So that extreme inflation that we experienced in 2022 and 2023 and 2024, we continue to build on those high prices, but at a lower growth rate.

So, prices are still rising, just not as rapidly as they once were. And when we look at core inflation, we just look at the August numbers, the August consumer price index, we saw the inflation rate. It was 2.9%. That’s headline. After we strip out things like energy and food which tend to be very volatile categories anyway, the core inflation rate is still 3.1%.

So this is very material, Josh, because back to that dual mandate the Fed’s target inflation rate is 2%. Now they use a slightly different metric than the CPI. But it’s very, very correlated to the CPI. The end result, the fact remains, is that even today, inflation is still about hundred basis points, a full 1%, north of the Fed’s 2% inflation target.

And if you are only looking at inflation right, it has a dual mandate. But if you were only looking at inflation you would raise interest rates in response to that.

I mean arguably right now the question–

That’d be the direction.

Yeah, directionally. I mean, we wouldn’t be talking really about cutting interest rates probably.

But the question I think that the Fed is struggling with, and we heard this back in 2022, 2023. The Fed famously said, well, we think the inflation that we’re seeing in the system is going to be quote, “transitory.”

Transitory.

That it was going to be like a one and done that things might pop up a little bit. But then we’re going to get back to the long term steady low inflation rate.

It’ll take care of itself.

It’ll take care of itself. It’ll go away at some point. And I think there’s some question today around the impact of tariffs. And many economists are showing in the data that there is tariff related inflationary pressure building up throughout the global economy, certainly within the U.S. economy. So it’s definitely there.

The question is, is it going to be persistent? Is it going to push up inflation? Is inflation going to stay high or is this really a one-time adjustment.

And so, I think legitimately the Fed is struggling, trying to understand that, trying to get their arms around whether or not this is going to ultimately quickly dissipate or if we are in, entering a new normal, where these tariffs are going to push inflation significantly higher and keep that inflation rate at a sustained high level.

What’s been the market’s view of this? The market — there’s inflation expectations in the market. There’s ways you bet on what the inflation rate is going to be. So we have a really day-by-day sense of what the market thinks inflation is going to be, right? And so what’s been the market’s reaction to the events of this past week where the Fed cut rates and signaled they’re going to cut them a little bit more?

I love your question, Josh, because the market is millions of global participants. It’s not just one economist. It’s not just the economists that sit on the Federal Open Market Committee at the Fed that sets interest rates. It’s not just the economists that advise the president. This is millions of investors the world over. And when we look at the inflation expectations currently that are set by the market, what we’ve actually seen, Josh, is that inflation expectations going forward have actually gone up, and not by a little.

Coming into the year. The forward looking inflation expectation set by the market was around 3% over the next 5 to 10 years. That’s an annual inflation expectation. That number has now gone up to almost 4%.

And we’ve seen a big jump in that just here over the past month or so. So that — the market collectively is saying that we think inflation is going to be materially higher over the next 5 to 10 years than what we thought was going to be the case as we entered the year.

Now, why is that? Well, we just cut interest rates this week. The inflation rate is still north of the Federal Reserve’s 2% target. And so I think objectively, legitimately, you could look at the data and say, well, wait a minute, we are pumping now more cash into the economy. The inflation rate is already running a little hot. This is probably going to continue to put jet fuel into the economy and push up the consumer price index going forward.

So I think there’s probably some truth to that. To be fair, there’s also questions around the true independence of the Fed. And like you and I have discussed many times, the independence of the Fed has waxed and waned throughout the Fed’s history. So this really isn’t a commentary necessarily on where we are today. I mean, you can look at where the Fed was under Arthur Burns in the 1970s under the Nixon administration. And you can look at where the Fed is today, where President Trump has appointed Stephen Miran to the FOMC, to the Federal Reserve Board.

The Federal Reserve’s independence has varied a bit throughout time, but I think it is true that a less dependent Fed should cause some concern among investors. Governments have a propensity to borrow lots of money, to spend lots of money, and politicians have a vested interest in keeping interest rates low, perhaps artificially low, and that naturally will push up inflation. And that could hurt the purchasing power of our portfolios.

And so I think as investors, I think that’s something that we should just continue to pay very close attention to. But I think it’s important that we also put it in a bit of a broader historical context. And I think just one last point. When we look at the administration’s economic policies, when we look at the backgrounds of their economists who are advising the president, most of the economists who are advising the president are in what we call the weak dollar camp. They are what we call devaluationist.

Their view is that the value of the US dollar is way too high. It’s hurting U.S. manufacturing and so on and so forth. But the value of the U.S. dollar is really high, Josh, because it is the world’s primary and preferred reserve currency. Central banks the world over prefer to hold a majority of their assets in U.S. dollars, and that pushes up the value of the U.S. dollar.

Many of the advisors, perhaps most of the advisors around the president are in the camp that we need to push down the value of the U.S. dollar if we’re going to better support U.S. manufacturing and things like that. One way to push down the value of the U.S. dollar is to cut interest rates. And so it comes as no surprise to me personally that Steve Miron, who is a voting member of the FOMC. He actually voted for a 50 basis point interest rate cut the other day, even though the majority of the other Fed members voted for a quarter point cut. And that’s naturally what we got.

Now, we’ve been talking about the inflation outlook primarily, but we started off, it’s a dual mandate. And the other piece of it is unemployment, the labor market job creation. What’s the outlook there?

Yeah, it’s a great question. Well, here’s what we’ve seen right. We have seen job creation really come down quite dramatically. It has stalled when we look at the data that comes out of the Bureau of Labor Statistics. It’s been in the news a bit again, a little political. The president fired the commissioner that runs that ran the BLS at the end of July.

So when we look at the data, what we observe is that the number of jobs being created in the US economy has come down quite dramatically. We’ve seen that bear out here over the past several months.

Now, here’s one of the challenges with measuring job creation, it is a survey-based exercise where the Bureau of Labor statistics, they’re sending out surveys to thousands of US businesses asking them who they’ve hired. How many have they fired. All of that data. The challenge is the survey response rate from businesses has really gone down quite dramatically post COVID.

And so I think government economists are having a hard time trying to measure what is really happening in the U.S. economy as it pertains to job creation. And so that’s why you see the Bureau of Labor Statistics. And they’ve always done this, by the way, Josh, they have to keep revising as they get new information, as they receive the surveys from businesses. They keep going back and restating what they think the job creation rate or the number of jobs created were at prior points in time.

Many politicians have accused them of manipulation. There is no evidence that no economists have manipulated the data. But I do I think–

It’s not a political it doesn’t look like there’s political manipulation.

Correct. There’s no evidence that there’s any political influence here in the numbers. I do think it is fair that from an econometric perspective, that these methods are not really capturing the information that we really want to know. And so there’s probably there’s certainly a need, I would argue, for better methods. I’m not an economist, so I don’t know exactly how to go about doing that.

But when we look at the data, what we’re seeing is that job growth in this country has stalled, and we have seen the unemployment rate slowly up to about 4.3% at the moment, to be fair, that’s not very high. Like when we actually look at the full span of the last 50, 60, 70 years, that’s actually pretty low by most measures that would count as quote, “full employment.”

And so I think the employment unemployment rate has only been lower than that 4.3% something like 16% of the time. So we’re actually in a pretty good place in terms of employment at the moment. Could the unemployment rate go lower? Yeah, probably. But we’re still in a really, really, really good place.

But I think what I’m hearing is that there’s a tension between the two goals. On the inflation side, you’re running a little hot. It’s not obvious that you would cut rates right now. On the unemployment side, there is some reason to be a little bit worried. There’s the data’s a little bit muddled. And parts of it are actually quite good, but parts of it are a little bit concerning. And so even leaving aside all the political questions of the moment, this is a tough economy for the Fed I think is what you’re saying.

I would say that reading the economy is always tough. I think it’s especially tough right now. I still think that the U.S. economy is really still reacting and adjusting to what has happened post COVID. We are adjusting to the rise of artificial intelligence. We’re adjusting to the rise of the gig economy. There is so much happening throughout the U.S. economy that I think, frankly, it is difficult. The Fed is in a really tough place trying to figure out what is happening in the U.S. economy and what data, if any should they be reacting to.

And then I think there’s another question around should the Fed be trying to preempt what they think might be coming in data going forward. Historically, the Fed has focused on responding to actual historical data. I think there’s a question around whether or not the Fed should be trying to preempt and forecast better, and then try to manage the economy prospectively going forward, rather than always relying on data that is coming in arrears.

So where the Fed’s landed for now, whether or not they’re right is they cut rates by 25 basis points. They’re going to cut another 50. It looks like is their plan. That could obviously change, but that’s the current plan. What do you see as the implication for us as investors from this path that they’ve charted out?

Well, I touched on the one already and I’ll restate it that I think from a very high level, we should pay very close attention to inflation expectations. Many of our clients are investing for retirement and education and things like that. And so paying very close attention to the expected purchasing power of our wealth naturally is important. That will have implications for how our advisors design asset allocations, design portfolios for our clients.

So paying very close attention to inflation expectations, I think is important to get a bit more granular. When interest rates go down, all things equal, bond prices go up. I’ve seen that in my own portfolio here this week. I’ve seen a little bit of a bump in bond prices. I was looking at the US aggregate bond index ETF AGG. That’s up about 1% here over the past month.

And the reason I looked at the past month, Josh, is that markets were expecting the Fed to cut interest rates a quarter point. So the market’s already priced all of that information into bond prices. So over the past month we’ve actually seen bond prices largely drift up to account for this cut in interest rates that we got on Wednesday.

Lower interest rates are going to make it easier for businesses to borrow. That’s going to help really help prop up these lofty valuations that we see already in the S&P 500. For example, we’re trading at about 22.5 times next year’s earnings.

This is a pretty high multiple that US stocks broadly are currently trading at. So that helps stocks. It helps real estate prices and things like that. Naturally we’ve seen a bit of a decline in mortgage interest rates here over the past month.

So that in theory should help push up home prices, things like that.

Now, for those investors who rely on bonds for income, this is going to hurt a little bit. We’ve seen this over the past decade or two with investors as rates come down. What does it mean? Well, it means they need to take on more risk in their portfolios in order to generate the income that they’ve become accustomed to or the income that they need to support themselves. And so naturally, a quarter point reduction in interest rates in theory, that’s going to hurt.

I emphasize in theory, Josh, because believe it or not, since Wednesday, since the Fed cut interest rates, we’ve actually seen the interest rates. The yields on longer term bonds actually go up slightly. So it’s not always true that when the Fed cuts interest rates that all bond yields go down. That certainly happens for these short-term bonds. These are bonds that mature over 1, 3, or 5 years.

But when you look at the 10 year bond, the 10 year US Treasury bond or even the 30 year US Treasury bond, many times you’ll see where those interest rates actually go up. And that’s to account for that increase in inflation expectations that we were talking about earlier. So we’ve seen actually interest rates go up slightly since Wednesday’s announcement.

And I think the last thing I would just say, Josh is back to the dollar devaluation conversation, we were having that weak dollar conversation. When you cut interest rates, again, all things equal, that pushes down the value of the U.S. dollar relative to other currencies, whether that be the Euro or the Yen or the British Pound. That is a nice tailwind for your non U.S. stocks, those non US assets that are in your portfolio.

So this is an argument for continuing to stay allocated to allocate part of your portfolio to international stocks. And we’ve seen this year where international stocks have substantially outperformed their U.S. counterparts. So at a high level those are really the investment implications of where we’re at currently in the U.S. economy and where we’re at. With respect to the Fed’s decision to cut interest rates on Wednesday.

One of the points you’ve made a couple of times, Don, is that the time to prepare for what comes next is when markets are riding high. And we’re in one of those moments now, I think right where there’s a lot of reason to take this opportunity to get prepared for whatever might come.

Absolutely. And that brings us back to great financial planning, making sure you have appropriate liquidity, making sure that your portfolio is exceptionally well diversified, not trying to forecast or predict where the market or the economy is going to go in the next six months, 12 months, or even over the next few years. But to just build a fortress balance sheet, a portfolio that’s really designed to weather really any storm, no matter what comes, is making sure that we’re on track to achieve our financial goals.

Well, Don, thanks so much for being here today for this discussion.

Thank you. Josh, it was great to be here.

If you’re already a Mercer Advisors client, don’t hesitate to reach out to your advisor to talk through and think through the way you’re positioned. And if you’re not a Mercer advisors client, but you’re interested in more information, head to our website merceradvisors.com. Set up a phone call. That’s how it starts. Thanks so much for being here with us today. This has been Market Perspectives.

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