Fed’s Progress Report: So Far So Good

Articles From: Invesco US
Website: Invesco US

By: Turgut Kisinbay and Robert Waldner

Key takeaways

November CPI

The latest Consumer Price Index (CPI) report revealed that inflation slowed more in November than markets expected.

Encouraging news

We’re encouraged by this inflation report as well as broader macro data. Inflation appears to be moderating and the details are in line with our expectations.

Fed tightening

Easing inflationary pressure takes some urgency off the Federal Reserve (Fed) and may allow it to slow the tightening of financial conditions.

The latest US inflation report was encouraging, in our view, and likely eases the pressure on the Federal Reserve (Fed). We believe it will remain cautious and somewhat hawkish in the near term — which we saw in action at Wednesday’s Federal Open Market Committee Meeting when the FOMC hiked rates by 50 basis points — but if inflation pressure continues to ease, we believe the Fed is likely close to the end of this rate hiking cycle.

What does the latest CPI report tell us?

The latest Consumer Price Index (CPI) report revealed that inflation slowed more in November than markets expected. Annual inflation fell from 7.7% in October to 7.1% in November, which is significantly below June’s peak level of 9.1%.1 Core inflation, which strips out volatile items such as food and energy, also dropped, measuring 6.0%, after peaking at a 40-year high in September at 6.6%.2

Monthly numbers matter the most for markets, and the November print was promising for the inflation outlook, in our view, as it suggested we could see ongoing disinflation without a sharp slowdown in the economy. The composition of the CPI was also promising, with core goods prices falling in recent months, and shelter inflation and other services inflation stabilizing. There was help from the global environment as declining energy and food prices helped the disinflation process.

Core goods prices have been declining

The much-awaited decline in goods prices finally showed up in November, as goods prices declined faster than expected. This was due to a rebalancing of demand away from goods to services and an improvement in global supply-side bottlenecks. The main contributor was car prices; used car prices declined, and new car prices were roughly unchanged. Other categories, such as recreation, commodities, and information technology goods, helped disinflation.

Shelter inflation is high, but market rents moved back to trend

While goods prices have been declining, the real battle for the Fed is the services side of the economy. Those prices are believed to be “stickier” and more sensitive to a tight labor market. While November core services inflation was not higher than expected , the evidence is mixed, and we believe there is more wood for the Fed to chop.

Importantly, a key component of inflation — owners’ equivalent rent and rent components — was up in November and remained at elevated levels. However, there is room for optimism. It is now well-known that CPI shelter inflation is slow to incorporate new market rents, as contracts are renewed gradually. Much of the increase in the CPI reflects past increases in market rents, but current rent data from private companies show that rent inflation is back to historical trends. As the CPI measures catch up with market rents, we anticipate that shelter inflation should moderate toward the historical trend as well.

What about non-shelter core services?

Non-shelter core services is the remaining part of the inflation puzzle. Fed Chair Jerome Powell talked about this recently  as the key area to watch, since these items are sensitive to wage growth. There was no bad news in November regarding these items. Medical care services costs declined notably, although those numbers may be unsustainably low. Hotels and airfare prices were down in November, a trend that has persisted for a few months. But there is probably still pent-up demand for travel after two years of a pandemic, so travel-related inflation may pick up next spring and afterward.

What does this mean for the Fed?

We’re encouraged by this inflation report as well as broader macro data. Inflation appears to be moderating and the details are in line with our expectations. The labor market is still tight, but it is slowing from very hot levels last winter. The adjustment toward more sustainable growth will likely take time. While the economy is moving in the direction the Fed would probably like to see, we believe it will remain cautious and somewhat hawkish in the near term.

Indeed, the Fed announced another 50 basis point rate hike at Wednesday’s meeting and expressed caution about easing financial conditions anytime soon. Powell acknowledged the good news from the monthly CPI data but indicated that the Fed needs to see further improvement and easing of the tight labor market before turning more dovish.  The “dot plot” indicates that the Fed is expecting to hike another 75 basis points in this cycle. Whether they deliver on this expectation will be dependent on upcoming inflation data in our view.  In short, we believe the Fed will likely continue to raise rates for the next couple of meetings for risk management purposes, but if inflation pressure continues to ease, it is likely close to the end of this rate hiking cycle.

Implications for the markets?

Easing inflationary pressure, as we see in the most recent data, takes some pressure off . The Fed has acknowledged that its policy impacts the real economy with a delay, and slowing inflation pressure reduces the urgency it is likely to feel.  The aggressive tightening of financial conditions so far this year has been a key driver of markets and had kept market volatility high.  Easing inflationary pressure should allow this volatility to ease. 

Markets are now likely to turn to the 2023 growth outlook for direction.  A soft landing would likely be supportive of equities and credit, but there is a significant risk of a recession, which would likely be negative for earnings and risky assets, such as credit and equities.  Recent inflation news is good for the bond market, in our view.  Declining inflation pressure and a more dovish Fed should cap yields, and bond yields are likely to decline if growth slows toward recessionary conditions. 

Implications for portfolios?

We believe an overweight to investment grade credit is warranted as companies are in good financial shape and the economy is slowing but still in relatively good shape, in our view. Interest rate volatility should decline, which would be a positive for agency mortgages as well. Investors have wanted higher yields but had concerns that inflation would become unhinged and the Fed would need to be even more aggressive, driving the terminal rate above 5%. Now that it appears the Fed may be nearing the end of its hiking cycle, and yields are still elevated on a recent historical basis, we expect that technicals should be positive for higher quality fixed income in 2023, driving credit spreads tighter. We think there will be opportunities in high yield, but we would favor the BB or higher rated portion of high yield as the lower rated CCC’s may struggle into a slowing economy.

With contributions by Matt Brill

Originally Posted December 14, 2022

Fed’s progress report: So far so good by Invesco US

Important information

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This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

All investing involves risk, including the risk of loss.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

High yield bonds, or “junk bonds,” involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.

The Consumer Price Index (CPI) measures change in consumer prices as determined by the US Bureau of Labor Statistics. Core CPI excludes food and energy prices while headline CPI includes them.

Tightening is a monetary policy used by central banks to normalize balance sheets.

The Federal Reserve’s “dot plot” is a chart that the central bank uses to illustrate its outlook for the path of interest rates.

The terminal rate is the anticipated level that the federal funds rate will reach before the Federal Reserve stops its tightening policy. The federal funds rate is the rate at which banks lend balances to each other overnight.

Credit spread is the difference in yield between bonds of similar maturity but with different credit quality.

A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other debts. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest); ratings are subject to change without notice. NR indicates the debtor was not rated, and should not be interpreted as indicating low quality. If securities are rated differently by the rating agencies, the higher rating is applied. Credit ratings are based largely on the rating agency’s investment analysis at the time of rating and the rating assigned to any particular security is not necessarily a reflection of the issuer’s current financial condition. The rating assigned to a security by a rating agency does not necessarily reflect its assessment of the volatility of a security’s market value or of the liquidity of an investment in the security. For more information on the rating methodology, please visit the following NRSRO websites: www.standardandpoors.comand select ‘Understanding Ratings’ under Rating Resources on the homepage; www.moodys.com and select ‘Rating Methodologies’ under Research and Ratings on the homepage; www.fitchratings.comand select ‘Ratings Definitions’ on the homepage.

The opinions referenced above are those of the author as of Dec. 14, 2022. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

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