US economy, Markets Will the Fed break investors' hearts?

An unexpectedly strong jobs report for January and an uptick in services PMI suggest the economy is more resilient than previously thought. And in a classic love-hate relationship, markets have pulled back on the good news as investors worry about what stronger economic data means for the Fed’s next move.

In our view, the CPI report for January served as a reminder for the Fed that it has more work to do in order to bring inflation down toward its 2% target. Inflation is clearly down from its peak, slowing to 6.4% in January from 9.1% in June, but this is still way too high for the Fed. Inflation has been slowing mainly due to declines in the prices of certain goods, especially those that became particularly overheated due to the pandemic. For example, at their peak, used-car prices were 55% above their pre-pandemic level, but they have been falling by around 2% a month in recent months. Smartphone prices are down 24% year-over-year. Consumer spending has been shifting away from goods and toward services, and supply chain bottlenecks have improved. The result is a better balance between supply and demand for many goods and less inflationary pressure. Lower gasoline prices have also been an important factor helping inflation to slow.

While this is certainly welcome news for both consumers and the Fed, it isn’t enough to bring the rate-hiking cycle to an end. Even if inflation continues to slow, the labor market still looks overheated, and it is unlikely that the Fed could ever consistently hit its inflation target unless the demand for workers cools off. The latest round of labor data is particularly problematic for the Fed. JOLTS job openings showed a big jump in December, and the latest NFIB survey of small businesses, also published this morning, showed an increase in the number of businesses with unfilled positions. In a pattern that is similar to the inflation data, various measures of wage growth have slowed from their peak levels, but are still too high to be consistent with the Fed’s inflation target.

The next FOMC meeting will be held on 21–22 March. Between now and then, the Fed will get only one more round of labor market and inflation data. It appears very unlikely that this data will be weak enough to convince the Fed to stop hiking rates. To the contrary, when the FOMC members sit down to fill out their projections for the economy and monetary policy, it seems inevitable that some members will lift their growth forecasts and their “dots” for 2023.

That would indicate an expectation that the Fed’s interest rate target at the end of the year will be higher than in the December projections. The market just recently caught up with the December dots, pricing in an additional 25 basis points of rate hikes in March and May, but the Fed could easily move the goalposts in the new dot plot.

Overall, the recent data suggests the risk that the Fed has to do more remains to the upside. We believe this warrants cautious overall risk positioning, favoring defensive sectors in equities and staying up-in-quality within fixed income.

Main contributors: Solita Marcelli, Brian Rose

Content is a product of the Chief Investment Office (CIO).

Original report - Will the Fed break investors' hearts?, 14 February, 2023.