by Joe Herrle, CFA
Vice President Alternative Assets
This week, all eyes were on the inflation report and the subsequent Federal Reserve announcement a day later. Since these were the last announcements of their kind for 2022, market participants were paying close attention, with the hope of gaining some insight into what the rest of the year might look like for markets.
Inflation Surprise
On Tuesday, the Bureau of Labor Statistics released the initial inflation report for November, and it brought a big surprise: inflation came in meaningfully lower than expected. While initially estimated to be 7.3%, headline CPI only rose 7.1% in November from the prior year, and 0.1% from the previous month. Inflation, not considering food and energy, was up 6% year-over-year and 0.2% from October, the smallest monthly advance in more than a year. While the rate is much higher than what we have grown accustomed to over the last decade, the November decline reinforces the belief that inflation peaked earlier this year.
One section of the inflation report to highlight is shelter costs. As measured by the report, rents rose 7.2%, accounting for more than half of the increase in core inflation (i.e., inflation excluding food and energy). While it continued to be a significant contributor in November, this inflation segment tends to lag the real economy more than other inflation measurements. There is strong evidence provided by private market participants, such as Zillow and apartment operators, that rent increases are still growing but at a slower pace. This should provide the Federal Reserve with more reasons to slow down the pace of interest rate hikes.
Source: Zillow and the Bureau of Labor Statistics
The Fed’s Response
The inflation report wasn’t the only surprise this week. The Fed also surprised markets with a more aggressive report than expected. As anticipated, the Fed raised rates by 0.50% to a range of 4.25%-4.5%. After four consecutive 0.75% hikes, this slowdown was pretty much a given going into the meeting. The language in the report was also identical to the previous issuance. What was not expected was a revision of the projected peak rate they expect to reach next year. The maximum rate most economists expected was about 5.0%. However, the Fed’s report upped the figure to 5.1%.
Fed chairman Jerome Powell built on the report in his press conference, saying that while interest rates are getting closer to being sufficiently restrictive, they’re not there yet. Despite the growing evidence that core inflation will fall next year, the Fed doubled down on its recent hawkishness, stating they need to see “substantially more evidence” on cooling inflation before they take their foot off the brakes.
The Market’s Reaction
The Federal Reserve showing such a firm resolve to end inflation with rate hikes was not well received by the market, with the S&P 500 declining over 3% that day. Adding to market woes, the November consumer retail sales report issued on Thursday disappointed. Black Friday and holiday shopping weren’t enough to bolster sales figures; the monthly drop of 0.6% was the greatest of the year and came in well below expectations. While consumers have proven to be resilient in the face of inflation and rising rates, growing prices and talks of a recession may have some hesitating when they reach for their wallets.
Due to more hawkish positioning, odds have increased that the Fed could overtighten financial conditions, leading to a recession. However, the employment market remains strong, and the average US household remains on solid financial footing. These facts lend credence to our belief that if a recession occurs in 2023, it will be short and shallow.
Takeaways for the Week:
Data released this week showed that inflation is cooling and likely peaked earlier this year.
Stocks finished lower on the week due to weak consumer sales and strong rhetoric from the Fed.