Conflicting signals in the economy show the Fed was right not to assume inflation would decline rapidly.
The Week That Was
Last Friday’s employment report suggested the economy remained strong in January. The report shows widespread job gains in a variety of industries, along with an explosive 13 percent annual increase in total hours worked. Signs of strength reduce the likelihood inflation will decrease.
Although the December S&P and ISM business surveys signaled the economy was declining, the January surveys were mixed. S&P shows declines in both manufacturing and service companies, while ISM shows declines in manufacturing and a meaningful increase for service companies and their new orders.
Both surveys show businesses are optimistic and expect any weakness in the economy will be short-lived. Hence, they are willing to hire now to prepare for a midyear upturn.
In terms of price pressures, S&P pointed to a slight uptick in prices; the ISM survey found prices falling but less than in December.
Weekly unemployment data show a decline in initial unemployment throughout January. These data are consistent with the January report of strong job activity.
Things to Come
The only significant economic event scheduled for this coming week is President Biden’s State of the Union speech and Arkansas Governor Sanders’ Republican response.
Market Forces
Investors had to digest a truckload of conflicting economic news this week. When it ended, stocks were mostly higher, with the S&P500 gaining 3 percent and the yield on 10-year T-notes only fractionally higher.
Amid all the conflicting signals, two things stood out. First, the economy appears to have been better in January than we expected. Second, the Fed was correct to tell markets inflation progress would be slow and further rate increases are likely. The Fed has enhanced its credibility, at least for now.
Although there are indications of significant declines in some areas, such as shipping volumes, the significant gains in employment outweigh them.
Even with signs of a slowdown, business surveys show widespread optimism for a midyear recovery. Businesses anticipate they will need workers once the recovery begins. Apparently, it will take signs of greater weakness before businesses stop hiring.
With the Fed, we expect inflation to continue in the 3 percent to 4 percent range in the months immediately ahead. If business weakens as we expect, inflation should move gradually to the Fed’s 2 percent target by year-end. If the economy fails to decline as we expected, inflation will remain stubbornly high.
Technical stock market indicators continue to improve. The S&P500’s 10-day average moved above the 50-day average two weeks ago. Thursday, the 50-day average moved above the 200-day average. These are positive technical moves.
Upcoming weakness in the economy should keep longer-term interest rates low and enable stocks prices to remain relatively stable.
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Outlook
Economic Fundamentals: negative
Stock Valuation: S&P 500 overvalued by 25 percent
Monetary Policy: restrictive
