Are Jerome Powell and I looking at the same data?

by Brian Levitt, Global Market Strategist, Invesco

Key takeaways

While watching U.S. Federal Reserve (Fed) Chair Jerome Powell’s conversation with Carlyle Group Chairman David Rubenstein at the Economic Club in Washington, DC on Tuesday, I was left wondering if Powell and I are looking at the same data.

Notably, Powell said, “The disinflationary process has begun but has a long way to go.” He acknowledged the improvements in goods inflation but suggested that service inflation remains sticky. He indicated that would likely be a reason for interest rates to go higher. Far be it from me to question a Fed chair. However, this is starting to feel like the other side of the “transitory” coin, with the Fed being late to acknowledge what the market seems to already know. In late 2021, they didn’t acknowledge that inflation had been let out. Now, it’s that inflation is falling rapidly.

The Fed is data dependent, so let’s look at some numbers.

Headline inflation: The six-month percent change in the Consumer Price Index has fallen to 0.94% from a peak of 5.43% in June. It stands well below the long-term average of 1.75%.¹

Core inflation: The rate of change in the core Personal Consumption Expenditure, the Fed’s preferred measure of inflation, is below the Fed Funds Rate.²

Money supply: M2 money supply growth, which has historically led inflation by roughly 12-18 months, has grown by 0% over the past year.³

Wages: Wages are slowing, notwithstanding the strong January nonfarm payroll report. Average hourly earnings are up 4.4% over the past year, down from a peak of 5.9% in March 2022.⁴

Rents: The survey of tightness in apartment markets from the National Multifamily Housing Council moved to record-low levels. This explains the recent slowing in rental price increases and suggests it should continue.⁵

Goods: The Retailers: Inventories to Sales Ratio, which fell to a historically low 1.08 during the worst of the supply-chain challenges, has climbed to 1.24 as sales moderate and inventories climb.⁶

Expectations: The one-year inflation breakeven (the difference between the one-year U.S. Treasury rate and the yield on the one-year U.S. Treasury Inflation Breakeven Security) is at 2.36%, down from over 6% last year.⁷

The risk to the recent market recovery trade is that the Fed commits to overtightening. That’s the Paul Volcker playbook from the early 1980s. Back then, it ended in a recession in 1981 and a near-term retracement of much of the gains that the market had made after inflation peaked.⁸ Despite it all, investors who had invested when inflation peaked in March 1980 were well rewarded over the subsequent three years and beyond. The S&P 500® Index advanced by 75% from the inflation peak in March 1980 through March 1983.⁹

My conclusion is that in the near term, we ignore the Fed at our own peril, but we take comfort in the inflation data moving in our favour. The Fed’s hawkish stance and any market volatility that arises from it are likely to be, well, transitory.

Footnotes
1 Source: U.S. Bureau of Labor Statistics, 12/31/22.
2 Sources: U.S. Bureau of Economic Analysis and U.S. Federal Reserve, 12/31/22.
3 Source: U.S. Federal Reserve, 1/31/23. M2 is coins and notes in circulation plus short-term deposits in banks and certain money market funds.
4 Source: U.S. Bureau of Labor Statistics, 1/31/235
5 Source: National Multifamily Housing Council, 1/31/23.
6 Source: U.S. Census Bureau, 12/31/22.
7 Source: Bloomberg L.P., 2/7/23.
8 Source of recession: National Bureau of Economic Research. Source of market returns: Bloomberg L.P., as represented by the S&P 500 Index, a market-cap-weighted index of the largest companies in the U.S. Indexes cannot be purchased directly by investors. Past performance does not guarantee future results.
9 Source: Bloomberg L.P. S&P 500 Index is a market-cap-weighted index of the largest companies in the U.S. Indexes cannot be purchased directly by investors. Past performance does not guarantee future results.