Inflation Fears Feed Fed Hawks

As inflation rates trended lower last July, the Fed raised rates sharply and the loud chorus of Fed critics claimed the Fed was too Dovish while inflation rose and too Hawkish as inflation fell. For the numerous managers and economists begging the Fed to pause its rate hikes in recent months, it appears now that our Central Bank wasn’t Hawkish enough. Last week the Fed’s preferred inflation gauge, core PCE, defied forecasts by rising to 4.7%, far from its 2% target. Service sector inflation, represented by Sticky CPI at 40-year highs of 6.6%, highlights the challenge for Fed Chair Powell. Significantly higher expenses and tighter lending standards have yet to dent consumption. With a resilient US economy at full employment today, Job One for the Fed is to bring down inflation as quickly as possible to prevent an embedded price spiral. It turns out that the fear of recession in early 2023 has been greatly exaggerated and the laconic attitude toward inflation is being replaced with a degree of alarm. Non-voting regional Fed Presidents, James Bullard of St Louis and Loretta Mester of Cleveland, said they saw a “compelling economic case” for a 50 basis-point interest-rate hike, seeking a quick jump to a 5.375% Fed Funds rate that could send a modest shock wave through the equity markets. 

While the US always leads the world in monetary policy, the current inflation crisis and Phillips curve extremes are not unique to America. Europe also has multi-decade low unemployment and 40-year high inflation today. In fact, European inflation is several percentage points higher than the US with a more arduous map to find the desired 2% rate.

Although Europe sports a much higher inflation rate than the US, its inflation fighting effort lags. After 8 years of negative European Central Bank (ECB) lending rates, the ECB is now considering back-to-back 50 basis point hikes. We feel the ECB needs a 75-point hike and the US a 50-point jump at the next meeting to dissuade businesses and consumers from excessive borrowing. Normally Central Bank lending rates rise above peak inflation (>9%). A 9 or 10% Funds rate will not occur, but 5.25 to 6% would be a rational expectation. If the March 14th US CPI report comes in hot, then expect a 50-point move at the March 22nd FOMC meeting.

Huge yield curve inversions, contracting purchasing manager indices and the leading economic indicator (LEI) have been emphatically forecasting for months that a serious economic recession was knocking on our doors. One of the limitations of these metrics is the long and variable timing, reducing its value for investors. We agree that a downturn in the economy with at least a modest uptrend in unemployment is coming, but not yet. The issues are what qualifies as a recession and when will it arrive. A general economic (GDP) contraction is “not” a recession. The National Bureau of Economic Research (NBER), the official arbiter of recessions, defines it as a several month decline in real GDP, real income, employment, industrial production, and wholesale-retail sales. While it’s their call, our definition in this overstimulated environment would be simply an above normal level of unemployment and debt defaults, as well as a year-over-year decline in corporate earnings. Unemployment and defaults are still very low while corporate earnings continue to grow, thus a recession claim in the near term should be impossible. The LEI and other recession warning proxies are a concern, but the enormous buffer of excess money in banks, companies and consumer checking accounts will require an extensive period of tightening to turn the current record worker shortage into a modest glut.

While primitive, one red flag to watch for will be the Sahm Rule when the 3-month moving average of the unemployment rate rises half a percentage point above its 12-month low or triggered by our simple filter at 0.2% above the zero line. Despite the reputation as a lagging indicator (which is true during recoveries), unemployment and this indicator tend to warn just prior to a recession. The debate over a soft landing or hard landing recession, or no landing continues and coincides with a related debate over stock market valuations. The disparity in professional forecasts has rarely been so disparate. Until the Fed finds the right level of restrictive monetary policy to curtail consumption enough to normalize inflation, we expect the stock market to be range bound until the later part of this year when downward economic pressure should have more of an impact on employment and earnings. Short term we expect a March low in equities over the next couple of weeks to trigger another rally phase through April.

 

 

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