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Murphy’s Law played out in dramatic fashion last year, as virtually anything that could go wrong seemingly did. The pandemic morphed into a new variant; Russia’s invasion of Ukraine ignited a spike in energy, food and other commodity prices that reinforced the worst inflation outbreak in 40 years; monetary policy embarked on the most aggressive rate-hiking campaign since the early 1980s; the stock market suffered its worst performance since the Great Recession; and the bond market fared even worse, enduring the most severe setback on record. Against this backdrop, all we can say is “good riddance” to 2022 and hope for a better 2023.
Has the inflation worm turned? It’s still early, but the signs are encouraging as an expanding list of price measures are pointing to slower increases. Whether this favorable trend continues is an open question; many factors underpinned the astonishing inflation cycle of the past two years and many don’t fit into conventional economic models that make predictions a bit easier. This is not a garden-variety demand/supply imbalance that traditional policies are designed to handle. Instead, the economy has been blindsided by a barrage of surprising external shocks linked to the pandemic, a disruptive war and climate changes – all of which continue to wreak havoc on prices. Indeed, the drying up of the Mississippi River – a major transportation conduit in the U.S. – is just the latest reminder to never count out the unexpected.
It's not a good sign when incoming data is accompanied by downward revisions to previous months, especially when the new data features downside surprises, as was the case with retail sales, industrial production and housing starts this week. Once that dynamic spreads to the employment data, we suspect that recession fears will escalate sharply. First, however, jobs data would have to come in weaker than expected, and so far that has not been the case. For sure, attention-getting layoffs in the tech sector are grabbing headlines, with more than 100,000 pink slips doled out over the past four months; that includes nearly 40,000 in January alone, which still has more than a week to go.
Is the third time the charm? The financial markets understandably greeted this week's report of slowing consumer prices with a good deal of optimism. For one, it solidifies perceptions that inflation has peaked and the Fed can ease up on its aggressive rate-hiking campaign. Indeed, the financial markets are more convinced now than a few weeks ago that the central bank will be cutting rates sometime later this year. For another, it also raises hopes that the Fed can accomplish its goal of taming inflation without sending the economy into a recession, bringing about the elusive "soft landing." That, in turn, would have positive implications for workers, businesses and investors as it enhances job security, strengthens earnings prospects and supports asset prices.
The jobs report on Friday understandably took center stage this week. Aside from it being a key barometer of the economy's underlying strength, when viewed alongside previously released data, it also highlights a growing debate that is gripping the financial community. At issue is whether the Fed needs to keep its foot on the monetary brakes until labor conditions weaken enough to slow wages – and hence inflation – or is inflation already firmly on the slowing path as the economy continues to normalize? For example, the anticipated post-lockdown shift in consumer spending from goods purchases towards services is having the predictable effect of easing price pressures on goods. That was brought into stark relief again in the ISM manufacturing report earlier this week that saw prices paid by goods producers plunge to the lowest level since April 2020 in December.
The U.S. economy is closing out the year with a whimper. True, there is still a full month of data yet to digest, and the all-important jobs report for December scheduled for release on January 6 will still depict a relatively tight labor market. But momentum is fading and the economy's main growth driver, consumers, is running out of fuel. The business sector is not poised to take up the slack and the Federal Reserve is not inclined to bail out the economy – at least not yet. Perhaps the biggest source of strength heading into 2023 is the federal government which is on the cusp of passing a $1.7 trillion spending bill, powered by a 9.7 percent increase in defense and 5.5 percent for everything else, a combined increase that adds a positive inflation-adjusted boost to overall activity.
It's been a rough week for investors struggling to digest the inflation/recession dynamic so vividly playing out in the headlines. The attention-grabbing Fed policy meeting ramped up the drama, albeit the half-point rate hike came as no surprise and the new Summary of Economic Projections compiled by Fed officials were also in the ballpark of expectations. Compared to the previous forecast made in September, the Fed now expects higher inflation in 2023 and 2024, higher unemployment and a higher target for its policy rate, suggesting that at least two more increases are in the cards next year. This week's half-point increase leaves the target range for the federal funds rate at 4.25 – 4.50 percent, which the Fed expects to lift to a range of 5.1 – 5.4 percent in 2023 – a half percent higher than the median forecast made three months earlier. Considering that the rate was sitting at near zero in March, this ranks among the most aggressive tightening cycles on record.