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The economy's roller-coaster ride continues. Last year ended with a thud, with consumers retrenching, inflation receding and financial markets slumping. Recession fears became more pronounced, as did expectations the Federal Reserve would soon pause its aggressive rate-hiking campaign to prevent a deep slump that would throw millions of workers onto the unemployment lines. Fast forward to this year, and the script has been flipped 180 degrees. The economy appears to be racing out of the starting gate; job growth soared in January, driving unemployment down to a 53-year low; consumers regained their spending mojo; and, most important, the inflation dragon is spewing more fire.
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.
The financial market turmoil stoked by bank failures and contagion fears dominated the headlines over the past week and will clearly have an influence in the upcoming FOMC meeting. But even without that external catalyst, Fed officials are confronted with another sudden realization, namely that data dependency is a two-way street. It will take a while to sort out the banking issues, and the tremors could yet cause more financial and economic damage than is currently envisioned. The swift and aggressive response by policymakers to short-circuit contagion temporarily calmed investor fears, but slumping stock prices and the plunge in Treasury bond yields on Friday suggest that the markets are not convinced the crisis is over.
The mixed messages coming out of Friday's employment report adds a layer of complexity to the Fed's rate-setting decision at its March 21-22 policy meeting. If nothing else, it imparts more importance to next week's inflation report, which could move the needle either way. If the CPI and its tangle of subcomponents come in hotter than expected, the odds of a 50-basis point rate hike loom larger; conversely, should this critical inflation gauge show more signs of cooling, Fed officials are likely to take a more cautious approach, keeping the rate hike at the smaller 25-basis point mark taken at the last meeting on February 1. Following Fed Chair Powell's hawkish congressional testimony this week, the markets priced in a greater probability of a 50-basis point increase, but Powell added a caveat in the second day of his testimony, noting that "no decision" had yet been made. We still expect the Fed to move by 25 basis points, but a hotter CPI next week would add an upside risk to that forecast.
All eyes are diligently focused on next Friday's employment report, the first significant reading for February, and not only for its intrinsic importance as an indicator of the job market's health. It will also give us a sense of whether January's surprising burst of hiring was an outlier, or a true gauge of the remarkable vigor shown in last month's report. We, like the consensus, expect a sharply reduced pace of job growth for the month, but it will be interesting to see if there are any major revisions to the January gain in payrolls, which the initial estimate put at an eye-popping 517,000, more than double expectations. That report triggered a profound reassessment of the economy's fundamental strength among investors and the Federal Reserve, setting in motion a dramatic shift in financial market trends. Since that report, which has been reinforced by other hard data revealing more muscular activity than thought, market yields have surged and stock prices have slumped, mainly in response to expectations of a more aggressive Fed policy.
The minutes from the Fed's policy-setting meeting early this month confirmed that the central bank is more concerned about inflation staying elevated than the economy slipping into a recession. Importantly, the meeting concluded three weeks ago when the economy looked much weaker than it does now and inflation had been retreating for most of the last half of 2022. Against that backdrop – which would understandably have justified a more lenient policy sentiment – there should be little question over what the Fed's next move will be, as incoming data since the meeting unambiguously supports a tougher Fed response. Unsurprisingly, subsequent comments by several Fed officials have sounded a more hawkish tone. In fact, the minutes revealed that two members of the FOMC would have voted for a half-point increase in the fed funds rate instead of the smaller quarter-point hike that was triggered, although the more hawkish opinions were held by nonvoting members of the committee. View the full weekly commentary PDF
Most January data are now in the books, and the general consensus is that the economy entered the year like a lion after exiting 2022 like a lamb. Indeed, following two months of steady downside surprises, the economic reports for January featured an avalanche of upside surprises. Both real activity and inflation indicators came in above expectations which, unsurprisingly, have led to widespread reassessments of the near-term outlook as well as of monetary policy. The bandwagon has made a near 180-degree turn over the past three weeks.
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