This isn’t a note about gender. It is a discussion of why the Fed and markets—two entities definitely in a relationship—aren’t really hearing each other. Consumer price inflation seems to be comfortably past the peak, falling to 7.1% y/y in November. This initially gave markets a false sense of comfort that was shattered by the hawkish projections from the Fed on Wednesdays Federal Open Market Committee (FOMC) announcement. We bridge the disconnect between the market’s dovish Fed pricing and the Fed’s continued hawkish stance. Markets risk getting too comfortable with lower consumer price inflation.
In November, CPI rose 0.1% m/m, when 0.3% was expected. Excluding food and energy, the gain was also a benign 0.2%, half the consensus expectation. This was the second month in a row that saw a downside surprise, giving badly needed relief and reinforcing the market’s sense the worst is behind us. Indeed, many of the factors we have been expecting to ease are indeed receding. Used car prices (-2.9% m/m), energy (-1.6% m/m) and airline fares (-3.0%) each shaved a noticeable chunk off the headline. Rent price inflation remains high and rose 0.7% in the month and 7.1% from a year ago. It is (by now) well understood rents will be stuck in higher gear for a little longer before easing around the end of Q1 2023. Our forecast is for CPI to ease in an uneven trajectory to 3.5% y/y by end 2023.
Consumer price inflation continues to surge
Source: Bureau of Economic Analysis, as of December 15, 2022.
Markets are ready to declare the fight against inflation over. (Let me be clear, this is premature. More below…). Right after Tuesday’s CPI release, futures soared with the Nasdaq at one point up over 4% before trading, although equities posted a more moderate gain by end of day on Tuesday. Importantly, the Fed funds futures curve fell, and markets reduced the “peak” Fed funds rate for this cycle from 4.99% to 4.83% on Tuesday and pulled forward some cuts from 2024 to 2023; the 10-year Treasury slumped 14 bps to 3.44% after the data, a two-month low. This pattern has repeated itself several times in 2022. Markets become enamored of the idea the Fed’s job is done, it will pause rate hikes soon and rate cuts shortly thereafter will be the next natural step. (Currently, markets have about two rate cuts penciled in for 2023). This dovish market-driven expectation causes the 60/40 to rally. Rinse and repeat in March, July and again in November.
At which point the Fed pushes back with hawkish language, which is what happened again on Wednesday. Against the moment of friendlier inflation data, the FOMC raised rates 50 bps as expected, downshifting from their 75 bps pace, but pushed back hard against rate cut pricing in 2023. The statement offered little news on the state of the economy, and noted “ongoing increases” in the Fed funds would be appropriate, language inconsistent with a near-term pause. The dot plot was also hawkish, with the terminal Fed funds rate in 2023 moving up 50 bps and 17 out of 19 members now expecting at least 5.125% Fed funds rate sometime next year. Perhaps one key difference now (vs. March and July) is that even after several days have passed and the hawkish FOMC meeting has been reiterated by several Fed speakers, markets aren’t listening. Market expectations of the terminal Fed funds rate remain at 4.85%, 25bps below the Fed’s 2023 peak, and the future curve has shifted markedly lower over the last month, much of this since Tuesday’s CPI reading.
Somebody is wrong…
Source: FOMC, as of December 15, 2022.
This is critical: The disconnect comes from the market’s bottom up, short-term view of inflation and the Fed’s top down, medium-term modeling. We’ve all become experts at dissecting the monthly CPI numbers, analyzing the contribution of swing factors, separating goods and services inflation, and using real-time measures (like Zillow) to estimate the six- to 12-month trend in owner’s equivalent rent (as an example). However, this has never been the Fed’s main focus. Indeed, one could argue this is why they missed evidence of pervasive inflation in 2021 in the first place.
The Fed’s models are based in the medium-term framework of the Philips Curve (the relationship between wages and labor scarcity), or deviation from long-run equilibrium unemployment. Lately, senior Fed officials are openly debating the Beveridge Curve, the relationship between job vacancies and the unemployment rate. All this is a fancy way of saying that for the Fed, these top-down dynamics of labor scarcity drive their expectation that a tight labor market will eventually put upward pressure on wages, inevitably (the theory espouses) cycling back into higher inflation expectations and persistent inflation. From this vantage point, with the unemployment rate at 3.7% and job vacancies high, their models are screaming for hawkish policy.
The graph below is a great example. Rents moved sideways to down early in the pandemic, then surged as they bounced back to trend and subsequently overshot. Now, markets are optimistic that falling rental inflation—the single largest component of CPI—will drag core inflation lower. We would agree rent inflation will slow meaningfully after the first quarter of next year. But over time, rents align with wages, and average hourly earnings are up over 5% y/y. Without a meaningful decline in wages and loosening in the labor market, rents are highly unlikely to settle into the 2.4% y/y average that dominated the 10 years before the pandemic.
Rents track worker pay
Source: Bureau of Labor Statistics, Zillow, as of December 13, 2022.
In my opinion, the probability of recession late next year is high. Yield curve inversion—I focus on the 3M to 10Y yield spread—is a function of Fed policy and reliably inverts nine to 18 months before a recession. This inversion happened again in late October. The Fed released their latest economic projections at the December 14 FOMC meeting, and frankly it doesn’t square with any historical outcome of any Fed rate hike cycle in decades. Their forecast is the economy avoids a recession but grows only 0.5% in 2023, the unemployment rate magically drifts up to 4.6% but inflation stays persistently higher. Notably, the core PCE deflator projection was increased to 3.5% for 2023, far above their 2% target, which they don’t achieve within their three-year forecast horizon. I see two main takeaways here: First, the Fed doesn’t have a better crystal ball, and their forecasts have missed for some time. Second, if the U.S. economy avoids a recession, growth is unlikely to be strong. The Fed is actively working to slow the economy down! Earnings forecasts and equity markets have not fully priced in a possible significant slowdown in nominal GDP growth (i.e., revenue growth) in 2023.
- The market obsession with CPI will continue, while the Fed will increasingly focus on wages, vacancy rates and other labor market data. Markets will likely continue to view the Fed as too hawkish, while the Fed sees the markets as griping for more liquidity and easier monetary conditions. Indeed, this is a problem of the Fed’s making—markets have gotten used to pushing the Fed into rate cuts in the past (when inflation and wages were much lower). This confusing dynamic could continue to cause bear market rallies that are vulnerable to correction.
- In 2023, wage and employment data will likely be more important than CPI data, despite possible market euphoria over an upcoming series of possibly friendlier CPI releases.
- Job losses are a coincident indicator of recession. I cannot stress this enough! While yield curve inversion is a leading indicator, if we see consecutive months of payroll declines, that will start the clock on a recession (unofficially). Don’t be distracted by layoff announcements of a thousand here and there. Our civilian labor force is 164 million people. By virtually every measure, the labor market has a lot of momentum and continues to look strong. Initial claims remains our favorite canary in the coalmine, and the canary currently looks healthy. Against this backdrop, the Fed is likely to remain hawkish.