As the U.S. economy begins to slow down in response to the Fed’s ongoing monetary restraint, another rate increase is likely at the Fed’s May meeting.
Recent data show the economy is beginning to respond to the Fed’s monetary restraint. In spite of these signs, recent inflation reports will make it difficult for the Fed to avoid another rate increase at the governors’ May meeting.
The Week That Was
Friday’s retail sales report showed a decline of more than 1 percent in March. However, this is a highly erratic number. For the first quarter, retail sales are up at a 5 percent annual rate from the fourth quarter of 2022 but only 1 percent over the past six months. The weakness in retail sales is consistent with our forecast of an economic downturn beginning now and extending through the balance of this year.
Friday’s March manufacturing report showed a slight decline of almost 1 percent from its peak last summer. So far, manufacturing is holding its own.
The CPI data for March show inflation remains in the 4 percent to 5 percent range. The good news is the year-over-year core CPI (ex-food and energy) is down to 5 percent. The bad news is the past three-months and six-month rates remain in the 5 percent vicinity. There has been no further decline in recent months.
Weekly unemployment data also have begun to signal a downward shift in the job market.
Things to Come
Most of the economic news this week will center on the housing market. Today’s Homebuilders’ Index for early April will provide the most current and best guide to housing activity. For eight months, the index has been below the break-even level of 50. It hit a low of 31 in December after mortgage rates rose to 7 percent. With mortgage rates now down to 6.3 percent, the April index should be up slightly from its March reading of 44.
On Friday, S&P wiil provide its advanced business survey for early April. The March surveys pointed to a slight decline in manufacturing and modest growth in service companies. Expect some further weakening in both areas in the April report.
Money, Money, Money
Monetary policy turned more restrictive in the first half of April. The decline was mainly due to banks continuing to shift funds from the economy into their own deposit accounts at the Fed. As a result, our measure of money shows almost $800 billion has been taken out of the economy since June, an 8 percent decline from a year ago.
Market Forces
Stock prices again ended the week close to where they were a week ago.
We are in an unusual period where stocks are prepared to move sharply in either direction. With monetary restraint likely to continue at least through May, stocks are vulnerable to another downward move. However, emerging signs of economic weakness mean the Fed is one step closer to ending its restraint, a positive for stocks.
Further signs of economic weakness will confirm the likely recession incorporated in the current yield curve for bonds. If monetary restraint continues into May, the Fed’s next rate hike is likely to be its last.
However, with inflation remaining in the 4 percent to 5 percent range, it is too soon for the Fed to be comfortable shifting to a less restrictive policy. Instead, the best we can expect is for the Fed to announce it hopes the upcoming rate hike will be its last. It can then
allow the lagged effects of restraint to work its way through the economy before assessing the governors’ next move.
For the moment, the Fed’s resolve to restore 2 percent inflation has convinced financial markets of a return to moderate inflation. As long as the Fed maintains its resolve, the 10-year Treasury yield can remain at or below the 4 percent vicinity.
Current longer-term interest rates assume all will go well for the Fed’s plan. We still assume there will be some hiccups in rates before this cycle is over. Given the increased likelihood the Fed will succeed and interest rates will remain lower, the fundamental value of the S&P500 is 3,700. However, we expect the S&P500 to remain in the range of 3,900 to 4,200 in the period immediately ahead.
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Outlook
Economic Fundamentals: negative
Stock Valuation: S&P 500 overvalued by 11 percent
Monetary Policy: restrictive