The Fed Recognizes Inflation’s Retreat; Financial Markets Celebrate

Despite the fact that markets were 90%+ certain that the Fed was done hiking, both the equity and fixed-income markets were surprised that the hawkishness, that had been so prevalent for the past 18 months, had completely disappeared. We were surprised, too! The dovish policy statement and Chair Powell’s demeanor complemented each other. We think that most of the Fed meeting was devoted to what the rate cutting cycle should look like and its cadence. Clearly, the Fed is now reading from the same hymnal as the markets regarding the inflation devil. Officially, then, the inflation war is over and the inflation foe has been vanquished. And, as we predicted in our September 22nd blog, “Higher for Longer” did prove to be “transitory.”

Market reaction was swift in both the equities and fixed-income markets. The S&P 500, already near an all-time high, rose 1.4% on Fed Day (Wednesday, December 13^th) and bonds had a monster rally as seen in the chart of the 10-Yr. Treasury whose yield touched 5% just two months ago. On Friday (December 15^th) it closed at 3.915% and, we believe, is headed lower.

Last Tuesday (December 12^th), the day before the Fed met, the odds of a rate cut at their March meeting was 40%. As of market close on Friday, they were 70%. The Fed’s Survey of Economic Projections (SEP), more widely known as the “dot-plot,” is published every quarter. The one published after the recent meeting showed a median Fed Funds Rate of 4.625% at the end of 2024, down 75 basis points from current levels (i.e., three 25 basis point rate cuts), falling another 100 basis points (four cuts) in 2025 to 3.625%, and then to 2.875% by the end of 2026 (3 more cuts) (see chart). And that is assuming a soft landing for the economy (i.e., no Recession). Of course, rate cuts will be swifter, and likely at the 50-basis point level, when the Recession arrives.

What happened to cause such an unexpected turn of events? We think that the reality of the rapid pace of disinflation finally set in, as we have discussed in our blogs for the last few months. Also, as noted by Rosenberg Research, the Fed’s own Beige Book, a quarterly survey of business conditions in each of the 12 Federal Reserve districts, told them that eight of the 12 districts reported either zero growth or actual declines, a result that was worse than Beige Book reports leading up to either the ’01 or ’08 Recessions.

In the after meeting press conference, Chairman Powell’s demeanor was anything but hawkish. While leaving himself and the FOMC an out in case inflation flared up, he admitted that the Fed’s hiking cycle was likely over, and that the next Fed move would be a cut. Once again, he didn’t commit to when the first rate cut would occur, but, as noted above, market odds show a 70% likelihood that the first cut will be in March. If history is any guide, the average number of months between the first pause and the first rate cut is nine. March is the eighth forward month (close enough for government work!).

Inflation – CPI

Playing a key role in all of this has been the inflation data. Both CPI and PPI reports came out this week, and both were supportive of the view that inflation had been beaten. The CPI, while still elevated in the year over year headline (3.1%), is actually exhibiting some signs of deflation, especially on the goods side. The table shows the annualized inflation rate for various time periods over the past year.

Note that over the past three months, inflation has quickly cooled, a major factor in the Fed’s move toward dovishness and the bond market’s view of when the Fed will first cut rates. To show how prevalent falling prices are, the next table shows price changes for the month of November for selected goods and services, examples of the disinflationary (deflationary) environment that the economy has entered.

Inflation – PPI

The Producer Price Index, a leading indicator of future CPI results, came in at a non-inflationary 0.0% in November. October’s reading was -0.4%. Year over year, the PPI has grown just +0.9%. If one looks at PPI items similar to what is in the CPI, one would find that reading was also 0.0% in November after a -0.6% reading registered in October.

Inflation Overview

The war against inflation appears to have been won! We even see this in the price of oil (left chart), now hovering around the $70/bbl. level (closed at $71.79 on Friday). It is way off its $93/bbl. September-October peak, and this is with disruption in Russian oil delivery to the West and OPEC+ discussing further output reductions.

Part of the reason the price could fall was that the production slack and then some was taken up by U.S. operators (right hand chart above). Note that U.S. production has been rising for some time, including at the peak in oil prices in September-October. Because of these factors, it appears that the bulk of the large fall in the price of oil has been from falling demand.

Even the prices of food and used cars, two poster children for this inflation plague, are on the wane.

Other Observations

The Rents Issue: The CPI has been buoyed higher by the lagging rents issue. But, as we get further and further into 2024, it will be pulled down by those very rents. As noted in prior blogs, shelter costs weigh in at a 1/3^rd weight in the CPI, but are lagged 12 months. In other words, the current CPI is using rents from a year ago. On the chart above, the purple line shows the true picture of rents (-1.1% in November) and how rapidly they have declined. The blue line is the rental number used by the Bureau of Labor Statistics (BLS) in the CPI calculations (7.2% in October), and the red line is the resulting CPI (3.2% in October).

By mid-2024, the CPI shelter component will be approaching negative territory. And, once there, it is likely to stay simply due to the record supply of new apartments that will be coming on line.

According to Rosenberg Research, the faulty shelter methodology used by the BLS added 220 basis points to the headline CPI. That is, the CPI would currently be below 1% if accurate, up to date, rents were used. So, it’s not a wonder why the Fed has turned dovish!

Banks – Lending and Delinquencies: The U.S. economy runs on credit. The left hand side of the chart below shows that banks have stopped lending, i.e., commercial and industrial loan balances are the same as they were a year ago. The right hand side shows that consumers have run out of gas. Note the steep upward slope in delinquencies. No lending; rising delinquencies – a formula for banking headaches and an economy that will come to a screeching halt without its needed flow of credit.

Final Thoughts

The Fed has finally recognized that inflation is dead. The November CPI and PPI reports nailed that. The rate at which rates will come down depends on the health of the economy. The next Fed meeting is in March. That’s when we think the first rate cut will occur. We have held this position for several months; nice to see that the markets have caught up (70% chance per Bloomberg).

There are too many companies announcing layoffs – it seems like every day another major layoff is announce. Challenger, Gray and Christmas data on layoffs and job openings have been downbeat. While Retail Sales for November surprised slightly to the upside, Johnson Redbook same store sales were quite negative, so we expect that November’s Retail Sales numbers will be revised down when December’s sales are announced in mid-January. In addition, Retail hired many fewer seasonal employees than normal, and we think this is a prelude to disappointing holiday sales.

We still see 2024 as a Recession year!

Merry Christmas and Happy New Year to all our readers!

(Joshua Barone and Eugene Hoover contributed to this blog)

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