The waiting game: Markets anxious for clarity from the Fed

Disinflation continues in Western developed economies, imperfectly.

Both US Consumer Price Index (CPI) and US Producer Price Index (PPI) for January were hotter than expected, but it was no cause for concern, in my opinion.

This CPI print in particular was a source of great market concern, as evidenced by the stock market sell-off that occurred that day. However, I think the reaction was not a reflection on the print itself, but on the state of confusion that exists around Fed policy (we saw outsized reactions all week to various economic data). The CPI reading was not hot — it just wasn’t cool enough for expectations. I am not rattled by it. Progress may be slower than expected, but we are moving in the right direction.

In fact, virtually all US CPI components are moving in the right direction. And yes, the shelter component remains elevated — but it’s easing. It’s just that shelter represents 42% of the core CPI index¹, so it has a big impact on the overall core CPI reading. And don’t get me started on how a large component of shelter inflation — Owner’s Equivalent Rent — can inaccurately reflect housing costs. It's also important to point out that the Fed’s inflation gauge of choice is Personal Consumption Expenditures (PCE), specifically core PCE, and that has been tamer and more strongly supports the disinflation narrative. (Even though some components of PPI filter into PCE, I don’t think January’s higher-than-expected PPI reading will have a significant impact on the next PCE reading.)

Another measure to look at is consumer inflation expectations. We got a reading last week from the University of Michigan Survey of Consumers that shows longer-term inflation expectations (five years ahead) remain very well anchored at 2.9%.²

On the other side of the pond, UK CPI was better than expected. Services inflation remains elevated, but that should be no surprise — we have seen goods inflation be a first mover, both up and down, followed by services inflation given the nature of consumer behaviour during and after the pandemic. The CPI reading seemed to have soothed markets, as it came on the heels of higher-than-expected UK wage data, which along with US CPI had caused some market gyrations.

I think a good analogy for inflation is weight loss. The path of weight loss is usually bumpy, even for those who faithfully stick to their diets day after day. One week could bring a big drop while another week could bring no progress, or even an increase in pounds. But while weight loss can be imperfect, if we stick with a long-term plan that’s tailored to our needs, we likely will reach our goal. The only difference is that monetary policy operates with a long lag, so we will very likely remain on a trajectory, albeit an imperfect one, to reach our target long after the first rate cut.

Retail and industrial demand is cooling

The NFIB Small Business Optimism Index for January clocked in at 89.9, its lowest reading since May 2023.³ In particular, the sales expectations sub-index fell quite dramatically. This survey is volatile, but it could be foreshadowing economic weakness.

US retail sales and industrial production also came in below expectations. US retail sales not only showed a significant decline last month, but November and December retail sales were downwardly revised. Perhaps all the headlines about planned layoffs are creating a more subdued consumer. The Fed wants to see a slowing economy before it cuts interest rates, so this is arguably good news as it should get the Fed more comfortable with cutting sooner.

We have already seen economic slowdowns in other countries. The most recent gross domestic product prints for Japan and the UK show each economy technically was in recession in the back half of 2023.

Of course, we have to be vigilant that the slowdown does not become too severe. I’m a big believer in the mantra “everything in moderation.” I’m prepared for a bumpier landing than most, but that does not mean a recession this year. I’m keeping my eyes out for cracks forming that might get too big.

I still expect the Fed to cut in the second quarter

Nothing I have seen in the data or heard in Fedspeak has changed my expectation that the Fed will begin cutting rates in the second quarter of this year. Yes, we have heard a lot of hawkish Fedspeak recently, but I continue to believe that Federal Open Market Committee (FOMC) members are using their voices as a tool to tamp down financial conditions and try to prevent markets from getting ahead of themselves.

I actually think it’s more instructive to hear from a former member of the FOMC who is no longer charged with keeping a lid on financial conditions but can simply share his policy prescription — former St. Louis Fed President Jim Bullard was historically a good bellwether of what the Fed was really thinking and planning to do. Last week, Bullard spoke at the National Association of Business Economics Conference and he was very dovish, arguing that current conditions indicate that the start of rate cuts should be now. He explained, “I think they should get going. It’s probably wiser to go sooner but slower…I’m worried that you’re going to get into the third quarter and policy rate is going to be too high for that situation, so why not go now.”⁴

US small caps have been hyper-volatile, confused by data and Fed speak.

While US stocks in general have experienced significant volatility recently, US small-cap stocks have been even more volatile. Every trading day of the last week saw the Russell 2000 Index move at least 1% in either direction.⁵ The biggest move came last Tuesday, when the Russell 2000 Index fell almost 4%, following the release of January CPI data. ⁵ Last week also saw a big move higher for the Russell 2000 Index — up nearly 2.5% on Thursday, helped by weak US retail sales.⁵

In recent months, US small-cap stocks have largely been driven by expectations about Fed policy; they have been more sensitive to economic data and Fedspeak — the factors that impact rate expectations — because they have historically been more driven by the economic cycle. The volatility experienced in recent days underscores market confusion and uncertainty about when the Fed will begin cutting rates and by how much. However, it also could represent opportunity for very significant mis-pricings depending on one’s economic outlook.

Changing monetary policy is a waiting game

In conclusion, last week was a reminder that monetary policy is still a critical driver of markets, which means we are all waiting for the Fed and other central banks to decide when to cut rates. While we wait, we can seek to take advantage of a more robust income environment by ensuring there are some components of our portfolio that offer adequate yield potential. That includes investment-grade corporate bonds, high yield bonds, municipal bonds, and of course dividend-paying stocks.

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