The Fed’s tightening of the money supply will further weaken the economy toward year-end and into next year. The public will suffer.
The Week That Was
The August CPI report was bad news. Although the collapse in oil prices held the total index to a 1 percent annualized rate, core inflation (ex-food and energy) rose at a 7 percent annual rate.
Even more discouraging is the report for a new measure of inflation designed to eliminate the impact of outliers. The August increase in this new measure was 9.2 percent annually, the highest in history.
Future inflation depends on the pace of spending. Yesterday’s retail sales data point to a significant slowdown in spending. Although sales were up 9 percent from a year ago, August sales were up at only a 4.7 percent annual rate from the second quarter.
Retail sales figures are notoriously erratic and unreliable. However, the latest numbers are consistent with a significant slowing in spending and a temporary slowing in upcoming inflation.
Amid all the uncertainty surrounding business conditions, businesses appear hesitant to lay workers off. Weekly initial unemployment claims fell to 215,000 in the first two weeks of September. This is down from 247,000 in July and 238,000 in August.
Money, Money, Money
The rise in core inflation makes it more likely than ever that the Fed will hike its target rate by 0.75 percent next week and consider raising rates higher and for longer than previously anticipated.
Financial markets, which had been anticipating a peak fed funds rate below 4 percent, now indicate a peak of 4.5 percent is more likely. An even higher rate is possible.
Things to Come
Later this morning, S&P will report its first September business survey. The August survey showed business activity declining. We expect the September survey to reaffirm the downturn.
On Monday, Homebuilders will release their confidence estimates for housing from earlier this month. With mortgage rates moving above 6 percent and substantial inventories of new homes, we expect the index to be down from 49 in August to the low 40s.
The Federal Reserve will provide its latest monetary policy views on Wednesday. We expect the Board’s governors to continue to increase the target range by 0.75 percent to 3 percent-3.25 percent. Financial markets now anticipate a peak of 4.5 percent by year-end.
More important than the widely expected increase in interest rates will be the Fed’s plan to sell securities. Previously, the governors said they planned to sell $95 billion a month. Selling this magnitude of securities for the coming months can send both the economy and stock markets into a more serious downturn.
In a highly erratic week, stocks first soared, then plunged. When the dust settled, the major indexes were down 1.5 percent to 3.5 percent for the week.
The shift in sentiment appeared to result from a shift in expectations of inflation. A week ago, expectations were for a moderation. After the bad inflation news, expectations shifted dramatically.
Technical indicators remain negative, with the 10-day averages below the 50-day averages, and with the 50-day averages below the 200-day averages.
Trading volume has been below average, indicating institutional investors are not very active.
Although the economic news has been mixed, I continue to believe that the economy is in the beginning of a downturn. With the Fed pulling money out of circulation and raising interest rates, the economy will get progressively weaker toward year-end and into 2023.
With the current corporate bond rate at 4.5 percent, the S&P500 is overvalued by 4 percent. If longer-term interest rates increase by a full percentage point, as is likely, the overvaluation moves up to 13 percent. Our model, which incorporates the potential for even higher rates, has the market overvalued by 22 percent.
As the Fed continues to take money out of the economy, we expect financial conditions to deteriorate further. The most likely trend is for a continuation of the downtrend in stock prices. It is difficult for stocks to rise when the Fed is taking money out of the economy. There is a growing potential for a steeper business downturn ahead.
Economic Fundamentals: negative
Stock Valuation: S&P 500 overvalued by 22 percent
Monetary Policy: restrictive
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