Phew, Good Thing CPI Was As Expected

As I write this morning, the S&P 500 Index (SPX) is literally unchanged. All things considered that’s a good thing for most investors. The index is up over 4% since the close last Thursday, just ahead of the December Payrolls data, and up 2% since Monday. The moves in the NASDAQ 100 Index (NDX) are more extreme, with that index down very slightly this morning, and up 5.9% and 3% over the same periods. Much of this week’s rally occurred in anticipation of this morning’s CPI data. Fortunately for those recent buyers, the data met expectations.

It is easy to understand why traders would have been betting on a post-CPI rally – we got substantial rallies after each of the past three reports. On December 13th, November 10th and October 13th, SPX rose 0.73%, 5.54%, and 2.6%, respectively. If the December rise seems modest, bear in mind that we had a mysterious rally just ahead of the report and a 3-4% spike in its immediate aftermath. It is also useful to remember that SPX bottomed on October 12th, meaning that the CPI report was the trigger for a broad market turnaround. Going into a CPI report from the long side has been working over the past few months, and traders like to repeat a strategy that worked in the past. (Never mind that SPX was -4.3% on September 13th, though)

Considering that expectations for month-over-month CPI were -0.1% for the headline number and 0.3% for the core, we had a high hurdle to beat. That is why I was concerned yesterday that the risks to equity markets were one-tailed. We had a high potential for disappointment and a very difficult result to beat. Think of today’s lack of action as a huge sigh of relief, particularly with weekly jobless and continuing claims coming in lower than expected. Today’s rhetoric from Fed speakers seems to guide us toward the potential for two 25 basis point hikes and then stasis. The Fed Funds futures market has adjusted about 3 bp lower in the short-term, with expectations for the March meeting shifting to about a 70% likelihood for a 25 bp hike from a near certainty yesterday.

But then what? We still see Fed Funds futures peaking in June, but now with the potential for three 25 bp cuts by this time next year. Why does this key indicator believe that the Fed will turn around almost immediately after achieving their goals? The broad consensus from key Fed officials is that they will keep rates steady through the end of 2023. We have gotten so accustomed to central bank accommodation that we appear to expect it, whether or not it is warranted. And if it is warranted, that would imply a weak economy that requires renewed stimulus.

Of course it is easy to say that the Fed is hardly omniscient. They were too slow to react to the inflationary pressures that were becoming obvious is 2022. Rather than implementing policies to fight inflation once it was obviously problematic, they took months to prepare markets for rate hikes and quantitative tightening rather than quickly taking action. Perhaps they were concerned about adverse reactions from asset markets, but they got them anyway.

But it is equally important to note that markets were just as incorrect as the Fed. At this time last year, Fed Funds futures were predicting that current rates would be just over 1%, not 4.25-4.5%. A key market indicator that is specifically designed to anticipate the Fed’s activities over the coming months blew it just as badly.

Exactly whom are we supposed to believe, then? Quite frankly, it’s not clear. My gut says that we shouldn’t be as dismissive of the Fed as the futures market suggests. For starters, they have shown impressive resolve once they got moving. They also have the ability to make themselves correct. The target rate doesn’t move until or unless the FOMC decides to move it.

Furthermore, the Fed is definitely cognizant of history, and in the case of inflation, that history is the 1970’s. During that decade, we had 44 months when headline CPI fell. Considering that there are 120 months in a decade, it means that the annual CPI reading fell over a third of the time even as inflation was generally soaring. It strikes me as hard to believe that the Fed will be any quicker to declare victory over inflation than they were to respond to its pressures.

On the plus side, there were literally no months when CPI fell on a month-to-month basis during the ‘70s (there were three 0% readings in the 1970-73 period). It is evident that inflation is nowhere near as problematic now as it was then. But the Fed wants to keep it that way. Even if they stop raising rates, it is hard to believe that they will cut them unless absolutely necessary – and they have warned numerous times that they will risk growth in order to defeat inflation. Bear in mind too that the Fed continues to shrink its balance sheet and has been nearly silent about the topic of quantitative tightening.

Today was a very solid result on the inflation front, even if it was largely priced in by the equity market. Now we need to look forward and consider what circumstances might allow the Fed to declare victory. One good month hardly permits that. And once their goals are achieved, it seems difficult to expect that they will immediately return to policies that could rekindle inflation unless circumstances require them.