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The Data Gains Ground on Reality

Several weeks back, we lamented the time it took for monetary policy actions to produce a result on a couple of key data points that define success in the Fed’s battle against inflation. Price stability, as measured by the change in the Consumer Price Index (“CPI”) and employment data (new jobs/unemployment) are bellwether indicators that drive policy changes by the Fed. The effects of interest rate hikes and the balance sheet runoff that began in March can take 9-12 months to be seen in these indicators. However, more current data and news from segments of the economy can provide clues as to where the key indicators are headed. There were signs of a slowing economy as far back as July. We viewed declines in manufacturing surveys and commodity prices, followed by Peak Housing and Peak Energy, as precursors of Peak Inflation.

Having connected the underlying dots, we were expecting something less than the recent 75bp rate hike at the November FOMC meeting. We were wrong. The Fed wanted more proof. Unfortunately, they got it too late in last week’s CPI report. Headline inflation came in below estimates at 7.7%, down from the prior month’s 8.2% and the third consecutive monthly decline. Taking that report and other ancillary data that reflect more current expectations, we see key data catching up to reality and Peak Inflation in the rear-view mirror. This should allow the Fed to dispense with super-sized rate increases in the future. The bond market agrees with that view as it posts a 40-year record inversion of its 2 and 10-year treasury yields, a fairly reliable indicator of slowing growth and a recession that has already been priced in by the stock market.

There’s been a change in tone to this week’s comments from some Fed governors who, in a reversal from a month ago, have now cracked the door open to the possibility of a tapered rate hike coming from their meeting of December 13-14th. We think it’s not only possible but probable, absent a surprise in the release of CPI data on the first day of that meeting. The Fed’s goal remains the same: Diminish demand, shrink the money supply, and move the economy to below trend growth. The effects of those are being seen on the ground in the real economy. However, it could take months and quarters before we see inflation within reach of the Fed’s mandate of 2%. Meanwhile, employment will have to fade a bit from record levels to convince the markets that the battle against inflation is won.

Is a soft landing still a possibility for the economy? Not according to the stock and bond markets. We no longer ask that question since investors have already paid the price of admission to a recession that is yet to come. Mid-December should provide an indication of where the next big move in stocks will take us. Stay tuned.