Federal Reserve Chair Powell changed his language about inflation to “more persistent” from “transitory” when speaking with lawmakers last week. He noted that the currently elevated inflation rate is likely to “linger well into next year.” There are a few themes at play with this pivot from the Fed. First, November consumer inflation (CPI) is likely to reach its highest level since the 7.1% year-over-year rise in 1982 if the consensus estimates of a 6.7% rate prove correct this week. Second, Powell is in the process of re-confirmation, and this allows him to show some action on inflation before the confirmation hearing.
Based on Powell’s comments last week, the Fed should vote to speed up the reduction in asset purchases at its December 14-15 meeting despite the downside risk from Omicron. The pace of tapering the purchases will likely double to $30 billion per month. In addition, while the headline reading on the November jobs report looked relatively weak, the details were much more robust and supported the Fed moving quicker to reduce accommodation. The unemployment rate fell to 4.2%, and hours worked climbed, signaling a healthy labor market. The household job survey showed strong employment growth even though job growth measured by the payrolls report was lower than expected.
Markets moved quickly to price in this new reality. The U.S. 3-month Treasury yield 18 months forward rose sharply and indicates almost four Fed rate hikes over the next year and a half, up from just one in September. The yield curve, which has accurately predicted most recessions when the yield on the 10-year U.S. Treasury has fallen below the 2-year, flattened to reflect a greater chance of a policy error from the Fed. While the yield curve is not near signaling a recession, the difference in these yields has fallen to 0.75% after reaching 1.3% in early October. Until recently, the yield curve has been persistently above 1% since February 2021.
If all goes according to Powell’s plan, inflation should moderate as the supply chain disruptions ease. That would allow the Fed to delay some rate hikes if needed to support the economy, and the market jitters over a possible 1980s replay of aggressive rate hikes required to break inflation do not need to happen. These hikes worked in the early 1980s, but not without the pain of smothering economic growth. This episode could be another in a long list of growth scares for the market, but it certainly should be monitored closely. The Atlanta Fed is currently estimating fourth-quarter annualized GDP growth of 9.7%, so growth is not a problem at the moment. While this growth estimate should moderate, the actual growth rate is still likely to be very healthy at the mid-single digits.
The trend of higher Covid infections in Europe was first flagged as a risk back at the end of October but finally saw some improvement last week. Infections remain very high, but time will tell if this is the start of an improving trend.
While the U.S. has seen a significant decrease in the pace of Covid infections since the September peak, the rate of change moved higher last week. The Thanksgiving holiday may have delayed some reporting, so care should be taken with the data again this week. So far, the high frequency and non-traditional economic data are not reflecting a change in behavior in the U.S. that would significantly change the economic outlook. One would expect air travel to be an early indicator if people were becoming uncomfortable again, but Omicron does not seem to be impacting it yet. The Thanksgiving holiday makes interpreting the data more complex, so the next couple of weeks will be crucial.
Stocks seem likely to remain choppy as markets digest the twin uncertainties of Fed policy and the Omicron variant. Fed rate hikes and rising yields are not inherently bad for stocks and other risk assets as long as they are consistent with the economic growth profile. The level of sticky inflation in the CPI report will be crucial for markets in setting the probabilities of an early 1980s redux.