Fed Pivots to Inflation Focus, Delaying Rate Cuts for Growth

The Federal Reserve’s recent decision to hold interest rates steady, while seemingly a pause, signals a subtle but significant shift in its economic calculus. This move, driven by stabilizing employment indicators and persistent, albeit somewhat elevated, inflation, suggests a pivot from labor market concerns to inflation management as the primary driver of monetary policy. The hidden consequence for investors and businesses lies in the potential for a prolonged period of monetary restraint, even as the economy shows signs of improvement. While the immediate outlook appears solid, the Fed’s focus on inflation means that any resurgence or stubbornness in price increases could delay anticipated rate cuts, creating a challenging environment for growth-oriented strategies. This conversation reveals that the path forward is less about stimulating employment and more about carefully navigating inflation, a nuance that could significantly impact financial planning and investment decisions for those who fail to grasp it.

The Inflation Tightrope: Navigating a Policy Shift

The Federal Reserve’s recent decision to hold interest rates steady, a move largely anticipated by markets, carries implications far beyond a simple pause. As Michael Gapen, Chief U.S. Economist at Morgan Stanley, explains, the Fed's rationale has subtly shifted. Previously focused on potential labor market downturns, the central bank is now primarily concerned with inflation. This transition means that rate cuts will be contingent on clear evidence of disinflation, rather than a proactive response to employment softness.

"The Fed was cutting rates on concerns about the labor market. The Fed felt there were downside risks to employment, so they were labor market-based cuts. But if they've upgraded the outlook, they say activity is solid. I think that's hard to deny that. And they said the labor market is at least has shown signs of stabilization. So I think what that means is cuts shift to inflation-based cuts."

-- Michael Gapen

This shift from "labor market-based cuts" to "inflation-based cuts" has profound consequences. It implies that even if economic growth moderates, the Fed will remain on hold until inflation demonstrably trends toward its 2% target. This creates a scenario where the economy might be growing, but the cost of capital remains elevated, potentially stifling investment and expansion for businesses that rely on lower borrowing costs. The risk here is that the market may anticipate rate cuts based on general economic health, only to be met with continued hawkishness from the Fed if inflation proves sticky. This could lead to market volatility and a reassessment of growth expectations.

The current inflation figures, hovering around 2.7% (with acknowledged data gaps due to the government shutdown), present a complex picture. While Fed Chair Powell suggests that much of the upward pressure is temporary and linked to tariffs, with domestic services inflation decelerating, there’s an underlying concern about the duration of this elevated inflation. Gapen acknowledges the data limitations but emphasizes the Fed’s overall confidence in disinflation. However, he also highlights the potential cost if inflation expectations become unanchored:

"How long can that happen and inflation expectations still remain stable, consistent, and low, right? So when if that market slips, if inflation slips and inflation expectations slip, getting that realigned would be costly in terms of economic output and perhaps on unemployment."

-- Michael Gapen

This underscores the Fed’s delicate balancing act. They are attempting to curb inflation without triggering a significant economic downturn or a loss of confidence in their ability to manage price stability. The consequence of misjudging this balance could be a prolonged period of economic stagnation or, conversely, a resurgence of inflation that requires more aggressive, and potentially damaging, policy interventions. For businesses, this means a longer horizon for potentially cheaper financing and a need to build resilience against inflationary pressures.

The Dollar’s Descent and the Search for Stability

The concurrent devaluation of the U.S. dollar, reaching four-year lows, and the significant run-up in gold prices have fueled discussions about a "debasement trade" and a potential loss of faith in the U.S. currency. While Powell dismisses rising gold prices as a direct signal for Fed policy, Gapen offers a more nuanced perspective, framing these movements as expressions of broader concerns about U.S. country risk.

The sheer volume of U.S. dollar-denominated assets held globally--estimated at $62 trillion--means there is no easy exit for investors seeking to divest. Instead, these concerns manifest in the currency’s value and, by extension, in assets like gold.

"The rest of the world holds a tremendous amount of US dollar-based assets. It's about 62 trillion that the rest of the world holds in US dollar assets... And so there's really no asset class where the rest of the world can say, well, we don't want dollar assets anymore, we're going to sell 62 trillion and move them over here, right? There is no other market to rebalance to."

-- Michael Gapen

This dynamic creates a situation where the dollar acts as an "escape valve" for global anxieties about U.S. fiscal policy, geopolitical risks, and trade dynamics. The consequence for the U.S. economy is a potentially weaker currency, which can boost exports but also increase the cost of imports, feeding into inflation. This is a direct feedback loop: concerns about U.S. economic management lead to dollar weakness, which can exacerbate inflation, necessitating tighter monetary policy, which in turn can slow economic growth. The administration’s rhetoric, often downplaying these concerns, contrasts with the market’s sensitivity to any indication of a weaker dollar, suggesting a persistent tension between political messaging and market realities.

Tech Giants and the AI Narrative: Shifting Fortunes

The earnings reports from Meta and Microsoft offer a snapshot of the current tech landscape, particularly concerning the burgeoning Artificial Intelligence (AI) sector. While both companies reported strong results, the market’s reaction highlighted a crucial distinction: the narrative surrounding their AI strategies.

Microsoft’s slight miss on Azure growth, despite still outperforming competitors like Google Cloud and AWS, led to an initial stock dip. This reaction, as explained by Gil Luria, Head of Technology Research at DA Davidson, was driven by investor pickiness regarding growth rates, particularly concerning the significant contribution of OpenAI to Azure’s performance.

"Having said that, just a few seconds ago, they guided that the next quarter will be a 37% to 38% growth. So I think investors will be able to relax a little bit, especially when they realize that some of the other numbers they reported, like remaining performance obligations for this year, are also up 39%, which is to say the growth of Azure this year is already in the books."

-- Gil Luria

The market’s focus on near-term growth figures, even when the long-term outlook remains robust, demonstrates a common pitfall: prioritizing immediate performance over sustained, underlying strength. The fact that 45% of Microsoft's remaining performance obligations come from OpenAI, a company seeking substantial capital, introduces an element of speculative risk. However, Luria argues that Microsoft’s position as OpenAI’s primary compute provider and investor offers a degree of security, ensuring payment even if OpenAI faces financial scaling issues. This highlights the complex interdependencies within the AI ecosystem, where a company’s success is intrinsically linked to its partners and suppliers.

Meta, on the other hand, received a more favorable market reaction despite its massive capital expenditure guidance ($115-$135 billion in CapEx by 2026). Luria attributes this to the strength of Meta’s core advertising business, which is growing at a remarkable pace, effectively giving CEO Mark Zuckerberg a "free pass" to invest heavily in AI infrastructure.

"That core Meta selling ads business is doing so well, investors are willing to give Mr. Zuckerberg a pass. He's still growing that ads business in the mid-20s, 24, 25%, which is remarkable at this scale."

-- Gil Luria

This contrast between Microsoft and Meta illustrates how narratives shape market perception. While Microsoft faces scrutiny over specific growth metrics, Meta benefits from the perception of a dominant, high-growth core business that can fund ambitious AI ventures. Luria also points out the current narrative premium placed on Google in the AI space, despite Microsoft and Meta demonstrating faster growth in their respective cloud and ad businesses. This suggests that the market is currently driven by a belief in Google’s AI supremacy, a narrative that Luria views with skepticism. The implication is that as the AI landscape matures, market perceptions may rebalance, potentially benefiting companies like Microsoft and Meta that are demonstrating tangible growth, even if their narratives are less hyped.

Adobe: A Value Play in the Age of AI

The discussion then shifts to Adobe, a company that has seen its stock price significantly decline from its peak, largely due to concerns about slowing revenue growth, increased competition, and the perceived threat of AI. Ed Herten presents a compelling case for Adobe as an undervalued investment, arguing that the market is misinterpreting the company’s position in the AI era.

Herten emphasizes that despite a slowdown from its hyper-growth phase, Adobe’s revenue growth of around 10% on a $24 billion base is still substantial, especially when compared to competitors like Canva. Furthermore, Adobe’s operational efficiency, evidenced by high revenue per employee and industry-leading gross margins (90%), demonstrates its underlying strength.

The narrative that AI will decimate Adobe’s business is challenged by the reality that Adobe is already benefiting from AI. Its AI tools have generated over $5 billion in Annual Recurring Revenue (ARR), and revenue per employee has increased significantly since 2022. This suggests that AI is not just enhancing Adobe’s operations but also making its products more valuable and, consequently, more profitable.

"In other words, AI is both enhancing the operations inside the company but also making the product better, which is why they're making more money off of it."

-- Ed Herten

The rise of short-form vertical video is presented as a significant, underappreciated tailwind for Adobe. As media companies and creators invest heavily in this medium, the demand for professional video editing tools like Adobe Premiere Pro is expected to surge. While competitors like Canva and Figma are acknowledged, Herten argues that the market is large and growing, with AI tools enabling more individuals to engage in design work, thus expanding the overall user base for companies like Adobe. The controversial nature of Figma’s stock performance is noted, but Herten reiterates his belief in Adobe’s fundamental value, describing it as a "wonderful company at a fair price" due to its strong financials and historically low valuation.

Key Action Items

• For Investors: Re-evaluate portfolios based on a Fed likely prioritizing inflation over growth, potentially leading to a prolonged period of higher interest rates. Consider assets that perform well in inflationary environments or offer long-term, stable growth.
• For Businesses: Develop strategies to mitigate the impact of potentially higher borrowing costs and persistent inflation. Focus on operational efficiency and pricing power to maintain margins.
• For Tech Companies: Clearly articulate AI strategies and demonstrate tangible ROI beyond speculative narratives. For companies like Microsoft, focus on communicating the long-term value proposition of cloud growth, even if near-term metrics fluctuate. For Meta, leverage the strength of the ad business to fund AI investments while clearly communicating the strategic vision for these ventures.
• For Adobe Investors: Consider the company’s strong financial fundamentals, high margins, and demonstrated AI integration as reasons for its current undervaluation. Monitor the impact of short-form video growth on Premiere Pro usage.
• For Policymakers: Acknowledge the market’s sensitivity to U.S. fiscal and geopolitical stability, as reflected in dollar valuation and gold prices. Clearer communication on long-term economic strategy could help stabilize currency markets.
• For All: Understand that the AI revolution is not a monolithic event but a complex ecosystem with winners and losers emerging based on tangible execution and adaptable strategies, not just hype.

Disclaimer: This blog post is an analysis of the podcast transcript and does not constitute financial advice. All claims and attributions are based solely on the provided text.