Financial markets are optimistic, with prices of stocks and bonds indicating investors think the Fed will quickly achieve its inflation target. We believe it will take longer to achieve its objective. That will put a damper on the economy for longer than the markets appear to expect.
The December CPI indicated inflation is down significantly from prior levels. However, the underlying rate remains close to 4 percent.
To maintain its credibility to reduce inflation, the Fed will likely continue to sell securities and raise its target fed funds range through at least the first six months of this year.
Things to Come
This week, December retail sales and manufacturing production numbers and the January Homebuilders’ survey are due.
Reports from retailers and shipping companies pointed to declines in business toward the end of 2022. We suspect December retail sales have declined for the second consecutive month following November’s 0.6 percent decline.
The Fed’s November measure of manufacturing production also declined by 0.6 percent. Reports of an ongoing decline in shipping volumes indicate manufacturing output in December likewise fell for the second consecutive month.
The January Homebuilders survey is likely to remain close to December’s low level of 31. The leveling off in mortgage interest rates since early December should help to prevent a further decline.
Market Forces
The financial markets are off to a good start in the new year, with stock and bond prices moving higher.
December’s CPI report is the latest good news. The core CPI rose at a 3.7 percent annualized rate. Although that is higher than November’s 2.4 percent rate, it is a slight improvement on the prior three months’ rate of 4.3 percent.
Financial markets currently assume the Fed will raise its target rate February 1st by 0.25 percent, to 4.05 percent to 4.75 percent. At the end of March, markets anticipate another 0.25 percent increase, to 4.75 percent to 5 percent, with a potential move back down at year end.
Market expectations will continue to change as economic data reveal the extent of any downturn in the economy and inflation. We continue to expect a moderate downturn in the economy during the first nine months of 2023. We also expect inflation to continue to decline, albeit slowly. If so, Fed policy will remain restrictive through at least midyear.
One reason longer-term interest rates are down is a growing sense that the economy is declining. Upcoming reports on retail sales and manufacturing likely will confirm the decline. Any news of economic weakness will reaffirm an optimistic case for lower inflation and an early shift away from monetary restraint.
Although we expect further signs of weakness for business, we remain skeptical about how quickly inflation will subside. We welcome all signs showing a rapid decline in inflation, but we believe the Fed will remain restrictive longer than markets now anticipate.
Stocks tend to anticipate conditions six months in advance. Recent gains reflect the likelihood of a swift decline in inflation and an early end to monetary restraint. Although that is possible, it’s more likely stocks and bonds will face still further headwinds before the current bear market has ended.
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Outlook
Economic Fundamentals: negative
Stock Valuation: S&P 500 overvalued by 22 percent
Monetary Policy: restrictive
