The extremely benign economic data of the past two weeks appears to have made investors more confident that they will win the fight with the Fed.
The unemployment rate fell to 3.5 percent in December, job openings rose, payrolls rose by 223,000, jobless claims have been flirting with dipping below the 200,000 mark, wages rose mildly but beat monthly inflation, the consumer price index (CPI) turned negative, consumer sentiment improved by more than expected, and year ahead inflation expectations fell to the lowest level in 18 months. As Bank of America investment strategist Michael Hartnett put it in a client note this week, it doesn’t get more Goldilocks than that.
Of course, when people describe an economy as having Goldilocks conditions, they typically ignore what happened shortly after the young woman found the porridge, chair, and bed that were “just right.” As yesterday’s Breitbart Business Digest noted, even in the much-celebrated CPI report released Thursday, there were worrisome signals. Services inflation reversed its two month downward trend to jump to 0.6 month-to-month, doubling the November 0.3 percent pace to 0.6 percent. On a year-over-year basis, the services CPI rose to 7.5 percent, the highest since 1982.
The Cleveland Fed’s 16 percent trimmed mean inflation metric also doubled, from 0.2 percent to 0.4 percent. Median inflation was unchanged at 0.4 percent. Core CPI, which excludes food and energy prices, rose at 0.3 percent in December, up from 0.2 percent the prior month. Our own “foodcore” inflation—which is just core inflation with food added back, also accelerated to 0.3 percent from 0.2 percent. The Atlanta Fed’s sticky-price CPI, which tracks prices that do not change rapidly, rose at an annualized pace of 5.6 percent, up from 5.5 percent in the annualized November figure. Core sticky price inflation accelerated for the second consecutive month to an annualized 5.7 percent.
While three consecutive months of benign inflation data indicate that we’ve passed peak inflation, the measures that indicate underlying inflation make a strong case that inflation is not going to come down very quickly. Indeed, it is likely that we’ve reached what Hartnett calls “peak Goldilocks.” With 1.7 job vacancies per unemployed person, a labor market still adding far more than the 75,000 or so jobs needed to keep unemployment stable, and households still smarting from the loss of buying power due to inflation, pressure on wages is likely to accelerate.
Fed officials are convinced that the imbalance between labor supply and demand needs to be remedied to put the economy on a path toward price stability. What’s more, they have said many times that the only near-term fix for the imbalance is to bring economic growth “below trend.” And since the Fed thinks that the long-term growth rate is around 1.8 percent, bringing growth below that more or less amounts to aiming for a recession. Fed officials say they will bring the benchmark interest rate above five percent, perhaps as high as 5.5 percent, and then keep it there until they are convinced inflation has been vanquished.
The market is not buying the message the Fed is selling. Jeff Gundlach, the leading U.S. bond fund manager, tweeted last week that there is “no way” the Fed would bring the federal funds rate above five percent. He expanded on this during a webcast for his DoubleLine Capital customers this week: “My 40 plus years of experience in finance strongly recommends that investors should look at what the market says over what the Fed says.”
The federal funds futures market currently implies that the Fed will hike by a quarter of a point at the February and March meetings, which would land the fed funds rate at a range of 4.75 percent to five percent. Prices indicate that there is only a one-in-three chance that the Federal Reserve hikes again in May after bringing the target to five to 5.25 percent. If you look out to the November meeting, the market thinks there is just a 12 percent chance of a five handle on the bottom of the range and a better than even chance that the top of the range will be 4.75 percent or lower. By December, the market is implying almost no chance that the Fed holds rates above five percent.
The market’s view of things really only makes sense if inflation keeps coming down rapidly or the economy enters a severe recession, both of which look unlikely. At the very least, we should wait to see a significant retreat in underlying inflation before being comfortable predicting a lasting downward trend. As Neel Kashkari, the Minneapolis Fed president, said about people betting on a rate cut this year: “They are going to lose the game of chicken.”