Is the Threat of Runaway Inflation Still Alive?
“The path of risk assets in 2023 depends on how far the Federal Reserve is willing to go in its interest-rate hikes to rein in once-in-a-generation inflation. But believing that the Fed has inflation under control today could be a painful mistake.
As we saw from the overreaction to Fed Chairman Jerome Powell’s speech on Nov. 30, investors are so caught up in the anticipation of a Fed pivot that they have overlooked the more important part of his comments.
While Powell indicated in his speech that the Federal Open Market Committee would soon begin “moderating the pace of rate increases,” he also said “it is likely that restoring price stability will require holding policy at a restrictive level for some time.” This is a far cry from the pivot that bullish market participants desire. He will probably raise rates again by 50 basis points, or 0.5%, in December.
Fed-fund futures suggest that the market thinks inflation will fall sufficiently over the course of the next six months to allow the Fed to pivot to cutting rates by June 2023. This type of pivot would result in a short-lived period of economic pain from high rates, followed by a return to relative normalcy by mid-2023, and would clearly be positive for risk assets.
However, the Fed may need to be even more aggressive next year to get inflation under control, pushing past 5% on the fed-funds rate. Markets underestimating that risk could lead to a painful correction in risk assets. There are several inflationary market forces that Powell will have to grapple with.
Despite a cooling housing market, the 12- to 18-month lag between home prices and rents (which count for a third of the consumer price index) means that shelter will be a major inflation tailwind next year. The S&P CoreLogic Case-Shiller national home price index peaked in July, giving us higher owners’ equivalent rent through January 2024. And even if home price increases slow from the current 10.6% year over year to 5%, say, that is still a historically high growth rate.
And while mass firings at tech companies like Twitter may give the anecdotal impression that unemployment is ticking up, the latest jobs report suggests that there is still not much slack in the U.S. labor market. Demand for labor will continue to put upward pressure on wages in 2023, which already increased by 5.1% this year, staving off the significant slowdown in consumer spending needed to cool inflation.”