THE WAR AGAINST INFLATION HITS A SPEED BUMP
Six weeks ago we wrote in the January mid-month commentary that the Fed was winning the war against inflation. If we look at their progress since last year’s peak inflation that is still true. But January hit a snag. While the backdrop for inflation has improved, the one inflation indicator that the Fed emphasized so aggressively over the past few months was the only one that did not show further relief in January. This measure, the personal consumption expenditure price index (PCE), rose 0.6% in January, up from 0.2% in each of November and December. Most of the increase came from the services side of our economy.
The latest PCE report reinforces the Fed’s view that it has more work to do to correct its great pandemic inflation mistake. The big question this week is how the Fed chooses to message the disappointing inflation numbers from last week. It seems clear to us that the FOMC (Federal Open Market Committee) would rather not see a sharp rally higher in stocks, especially if that rally is due to higher valuations as opposed to stronger earnings. Further strength in stocks might spiral to consumers and businesses to spend more while bolstering balance sheets which would add to inflation pressure. This is a classic “Don’t Fight the Fed” market.
The Fed is tightening monetary policy at the fastest pace in 40 years. Furthermore, the economy is more leveraged than any time in history and, therefore, more sensitive to interest rate increases. We think it is naïve to assume a recession is not probable because a lagging economic indicator, like employment, remains robust. We still think it is very likely a recession will start later this year. Market bottoms usually occur about halfway through a recession. A bear market has never ended before the start of a recession.
With the Fed now slowing the pace of rate hikes, perhaps markets were lulled into thinking the Fed was on their side during January’s rally. You can hardly blame them. Markets received virtually uninterrupted monetary support for nearly 15 years before beginning the inflation fight in 2022. Considering the Fed did not come to the rescue of markets back in October, there is no indication they will be more sympathetic going forward. In our view, the bear market will continue for a while longer.