Inflation Data Pushes Pause Button on Rate Hikes

The emergence of a consumer price index (CPI) to measure inflation was conceived by an English economist in 1822. Its popular use germinated in 1917 as World War I raged, and many goods soared in price.  Without tax funding for the War, Central Banks printed money that stimulated excess demand and persistent inflation near 20% for several years in the US and over 100% in parts of Europe. Our Central Bank (The Fed) has learned new tricks in our modern fiat currency system with the monetization of hyperbolic Government spending when politicians see an opportunity to buy votes. After the Fed funded the Government’s record fiscal inflation of the economy from 2020 to early 2022, the Fed finally began pursuing their mandate of price stability.  So far, Fed Chair Powell has demonstrated how adept he is in maintaining the all-important investor confidence while draining the banking system punch bowl by $800 billion and ratcheting interbank borrowing rates from zero to 5.5%. If Fed Chair Powell avoids a labor recession over the next year after such a rise in borrowing rates, it may be an historical first for any Central Bank. Monetary brakes have brought the Fed’s preferred inflation metric (core PCE) down from 6% to about 4% today. While this is far from their 2% objective, perhaps the inflation battle has already been won (see chart below) when removing energy and the lagging housing segment from the inflation index. The Fed is aware of the deflating goods sector and lag effect from housing, but they still need more evidence of falling prices to avoid another rate hike this year. Inflation will be sticky, but the underlying trends are healthy.

Full employment and persistent supply shortages of planes, trucks, automobiles, and housing indicate an economy that is not on the edge of a recession. However, inflation has eroded incomes over the past few years. It has been the worst three years for inflation adjusted disposable income in history, but consumer bank accounts remain higher than pre-Covid and credit spreads reveal no banking anxiety to date. With incomes this year growing faster than inflation once again, there is still time for the Fed to thread the needle and avoid a hard landing recession.

One of, if not the only, true red flag among economic metrics this year has been the rapid credit tightening among banks. Eventually, tighter credit will curtail spending and slow the economy. Current credit card loan standards historically coincide with an economy that is already well into a deep labor recession. For now, the banking sector is well capitalized and being proactive to discourage consumers from carrying higher credit card balances. The annual growth rate of core consumer spending, excluding inflated food and energy, is 4.2% and remains at more than 30-year highs. The Fed needs to keep tapping the monetary brakes until consumption growth disinflates to a more sustainable 2% rate long term pace without triggering a labor recession. 

Labor is a key metric that may lag during economic recoveries but is coincident and sometimes a leader as the economy enters recession. Continuing claims for unemployment insurance is a nice measure of potential labor slack. The rise in claims from last year’s historic low indicates that labor isn’t “extremely”, but it remains far below levels indicating slack. Historically, claims rise through 2.5 to 2.6 million before a spike to recession levels of unemployment become a reliable forecast. A slowdown this winter into early 2024 is what we expected a couple of years ago and a new uptrend in unemployment claims is required to provide confirmation.

The 120% Bull market move ending in 2021 was all about non-stop stimulus from overblown concerns over Covid. The 2022 Bear market decline of 27% was about removing the extraordinary stimulus froth from the top of the beer mug. With inflation steadily falling and a surprisingly robust full employment economy, 2023 increasingly keeps money managers optimistic, targeting the elusive end to bank credit tightening. 

Since the major bottom in stocks 11 months ago, the broader stock market, excluding large cap technology, has been sideways. For major indices like the S&P 500 and Nasdaq Composite that are dominated by the top 6 US technology stocks, the past few months paint a far more Bullish appearance. Investor insouciance to a tripling in mortgage rates and restrictive lending standards obscure weaker stock market breadth among the broader market of equities. The Nvidia AI boom since May has obscured small and mid-cap market weakness by elevating large cap valuation multiples to levels inconsistent with current interest rates. The 15 and 46% gains this year in the S&P and top 10 mega caps show unrealistic returns, while other major indices manifest more pedestrian single digit gains. The persistent worker shortage and promise of massive productivity improvement from AI keep investors undeterred by the continued Fed mantra of higher for longer interest rates and credit tightening. The majority are forward-looking and without any serious economic deterioration, wealth managers will stay invested, anticipating the over-forecasted end to a tightening monetary policy.

 

 

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