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Beyond the headlines: good for the Fed, not for markets


May 13, 2022

Chief Economist Eugenio J. Alemán discusses current economic conditions.

Data on the US economy during the week was, let us say, as expected, but not as markets would have liked according to the reaction on Wall Street.

However, let’s take a minute and recall the introductory letter I sent when I joined Raymond James as its new Chief Economist earlier this week. In that letter I told the story of the behavior of different economic variables and how some variables take the ‘elevator’ while others take the ‘stairs.’ Well, we witnessed this during the week with financial markets plunging in the elevator while the news on the economy showed some promising steps up this stair of reining in inflation and inflationary expectations.

We discuss this in the section below entitled ‘Inflation and the Fed.’ But for now, it is also important to note that not only do economic variables react differently in terms of speed, i.e., elevator versus stairs, but also in terms of direction. In economic terms, this week’s inflation numbers, consumer prices, producer prices, and import prices, while not perfect, pointed in the right direction.

However, markets were not happy with the positive direction inflation had taken and reacted negatively to those numbers. Markets seem to have wanted more than what these economic variables were willing to give and thus they reacted accordingly.

In some sense, markets are correct even if the size of the correction seems overblown. However, even the Federal Reserve (Fed) Chairman, Jerome Powell came out saying that he “can’t guarantee a ‘soft landing’ on May 5, 2022. However, Powell added that “Nonetheless, we think there are pathways…for us to get there.” We agree that this path will be tricky, and the Fed Chairman and his colleagues will need all the help they can get for a soft landing to come to fruition.

As we point out in the next section, there are some good things happening: the moderation in real disposable personal income growth, which is a harbinger for slower inflation, see Figure 2 below; the appreciation of the US dollar, which will help keep import prices from contributing more to inflation as well as the fact that the Michigan Consumer Sentiment Index one-year ahead inflation expectations has stabilized while five-year ahead expectations remain well anchored.

Thus, although we agree with Fed Chairman Powell that the road ahead will not be easy, e.g., soft landing, there are many tidbits of economic information that are reassuring for putting the US economy onto a slower growth path that will help bring inflation under control.

Inflation and the Fed

Will the latest CPI numbers give the Fed pause?

The latest CPI release was a mixed bag for the Federal Reserve and for markets. As markets were expecting, the year-over-year number came down because we are now comparing to a lower base number in April of 2021. The Fed would hope that this trend continues as the year progresses. At the same time, energy prices, driven fundamentally by lower oil prices, helped the overall index. However, May’s release will be a bit different as oil prices have reversed course and are on an upward trajectory again.

Thus, the Fed will not be as lucky in the next couple of months as the summer driving season approaches. Furthermore, we expect the economy to continue its path to full reopening after two years of pandemic slowdown.

What the Fed would like to see is a further slowdown in core goods prices, especially if the economy fully reopens during the summer and core services prices continue to recover. That is, the Fed needs to see more moderation in the rate of growth of goods prices and hopes that food and energy prices do not continue to go up.

As the figure below shows, core goods prices have started to come down and if this pattern continues, this will be good news for the Fed. Furthermore, it would also like to see some moderation from core services prices considering that services are about 70% plus of total core goods.

Meanwhile, inflation is doing its part in helping the Fed. The increase in real disposable personal income brought about last year by the fiscal package has dwindled and income growth has slowed considerably. When inflation increases real incomes are negatively affected and this time around is no different than in the past, as the graph below indicates.

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Thus, we should expect inflation to continue to moderate as the year progresses as incomes will not be supportive of strong growth in consumption. The only caveat will probably be consumers’ use of accumulated savings. The personal savings rate stood at 6.2% in March so there is some live ammunition in case consumers decide to continue to splurge for a while.

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The Fed has been very effective in pushing long rates higher as shown in the strong increase in mortgage interest rates. This will further help to slow down the housing market and contribute to the ‘proverbial,’ but slippery, soft landing that markets hope for.

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Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those Raymond James and are subject to change without notice the information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Studies. Currencies investing are generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

The National Federation of Independent Business (NFIB) Small Business Optimism Index is a composite of ten seasonally adjusted components. It provides a indication of the health of small businesses in the U.S., which account of roughly 50% of the nation's private workforce.

The producer price index is a price index that measures the average changes in prices received by domestic producers for their output. Its importance is being undermined by the steady decline in manufactured goods as a share of spending.

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