Stocks fell 4% yesterday after a shockingly bad report for consumer prices in August. It was the worst day for stocks in over two years. The August increase in core prices (ex-food and energy) of 0.6% was twice expectations and virtually assured that the Fed would increase interest rates at least 75-basis points for the third consecutive month when the FOMC meets next week. Unless the September report shows substantial improvement on the inflation front, investors can expect another 75-basis point increase in November. Two more 75-basis point increases would bring the Fed Funds rate to almost 4% by year end. Markets now predict the rate will rise to at least 4.5% early next year. The odds of recession have clearly risen.
I don’t want to overstate the importance of one inflation report. There continue to be signs that pricing power is ebbing while commodity prices slide. Home prices have peaked. Ultimately that will show up in shelter costs, which make up more than a third of the CPI. In August, shelter costs rose 0.7%, the highest single monthly increase in decades. While numbers can bounce around from month-to-month, yesterday’s report clearly makes the point that inflation won’t be defeated easily. All the easy money and fiscal stimulus of the past several years fed the inflation beast. Higher rates, only initiated in March, take many months to filter through the economy. Their impact is barely evident so far. By early next year, the impact will be apparent. Mortgage rates now exceed 6% and are climbing. Auto loan rates will soon crush auto sales. Credit card rates exceeding 20% will soon be common for all except those with the best credit scores.
Have no doubts. The Fed will defeat inflation. The two big questions are what will the collateral damage be, and how aggressive will it be picking up the pieces after inflation is crushed? A lot has been written about the hyperinflation of the 1970s. Three times inflationary pressures were arrested only to return with a vengeance before Paul Volcker instigated two back-to-back recessions to defeat it. What gets lost is the fact that Treasury and the Fed increased money supply at double digit rates twice after inflation was subdued in the early and mid-70s. Today, money supply isn’t growing at all. It hasn’t since December. Bank deposits fell a record $370 billion in the second quarter as depositors sought higher interest rates. Banks have been flush with cash; the withdrawals did no immediate harm, but it’s a trend that can’t be repeated too long without consequences.
When the June inflation report surprised markets, the FOMC immediately ratcheted up its pace of interest rate increases. Markets now say that a 100-basis point rise is more likely than a 50-basis point rise although 75 is still the logical estimate. There is danger that the Fed could be too reactive to one month’s inflation report. Remember, the June surge was followed by a flat number in July before yesterday’s disappointing August number. There is something to be said for looking at rolling 3-month trends. Those point lower but not at a pace the Fed wants to see. Nonetheless, while the focus this morning is on yesterday’s CPI report, the Fed needs to be cognizant that, given the time lag between rate increases and their economic impact, there is risk of overkill. To release wage pressure, some increase in the unemployment rate is necessary, but does “some” mean 4.5% or 6.5%? If the economy starts losing hundreds of thousands of jobs each month, the Fed will be under a lot of pressure to relax its tightening stance.
The reality is that the Fed doesn’t know what it may or may not have to do next year. So far this year, its own forecasts for the next FOMC meeting have been wrong more often than right. What its members have said is that it will need to see sustained progress lowering inflation before it changes policy. I would take that to mean that core inflation would have to be below 3.5% for at least 3 months and probably longer, for the Fed to consider reversing course. Looking at that number on a monthly basis, that suggests core month-to-month increases of no more than 0.3% for 3-6 months.
So far, despite rate increases to date, consumer spending has been remarkably resilient. Perhaps that relates, in part, to the money Congress doled out during the pandemic. But, around the edges, the impact of higher rates is beginning to be felt, especially in those industries that rely on borrowed money like housing and auto sales. Airline ticket sales are also starting to ebb, and prices are coming down. Weekly jobless claims have started to rise, and the pace of job growth is slowing although still robust.
Hopefully, by this time next year, the full impact of Fed policy will have muted inflation and allow investors to look over the horizon to more accommodative policy. Which brings me to the central question that should be on investors’ minds. When does the suffering in financial markets end?
If stocks reflect the outlook 6-9 months out, today they should reflect what the economy and inflation look like in the spring of 2023. That is what’s priced in today, the composite expectation for next spring. Of course, that can change. Yesterday’s CPI report probably changed it for the worse, for instance. But long-term investors must look out further. If today’s prices reflect the world 6-9 months from now, the next spring markets will be discounting Christmas 2023. I don’t think anyone has a crystal ball that will tell you what Christmas 2023 is going to look like. Heck, we don’t even have a clear picture for Christmas 2022, but one doesn’t need a clear picture. Is Christmas 2023 going to be better or worse that Christmas 2022? That’s a more astute question. What I am getting at is trying to define when markets may bottom. I suggested more than once that October 2022 could be a logical time. Why? Because if the Fed is finished raising rates by early 2023, a process started this past March, most of the impact will be felt by next summer. Hopefully, by then inflation will be down, maybe not all the way to where the Fed wants it to go, but well on the way. Earnings will come under pressure soon and probably remain under pressure well into 2023. Market interest rates will start to come down well before the Fed starts cutting the Fed Funds rate.
Yesterday’s decline simply erased gains of the previous week. We have been right in the middle of the 3600-4300 range for the S&P 500 since May. Until those outer bands are violated, I would suggest we remain in a trading range. Volatility will remain elevated. Bottoming is a process. The June lows may or may not hold. The odds of a significant recession remain low. We don’t face the structural problems that the banking industry faced in 2008. We simply need to rebalance supply and demand. That will take time but doesn’t require severe pain.
I want to end by repeating that once inflation comes back to target, the growth outlook for the economy isn’t pretty. 1-2% is all that is sustainable given demographics around the world. Any efforts to induce faster growth over any sustained period risks reigniting inflation. Because no matter what the Fed does, the economy won’t have the excessive slack that evolved out of the 2007-2009 financial crisis. Both inflation and interest rates are likely to be a bit higher than the sub-2% levels of the 2009-2021 period. Bond cycles are long, often spanning decades. I don’t envision Fed Funds rates going back below 2% for many years. It wouldn’t surprise me to see long-term rates rise above 4% and stay there. There should be a real cost to borrow money. The fact that there hasn’t been for so long is precisely why we have the inflation we have today. For decades, businesses thrived while there was a real cost to borrow money. Real cost reduces the amount of dumb investment which, in turn, reduces excess supply and economic inefficiencies.
The next drama point will be next week’s FOMC meeting. The focus will be beyond what the Fed does then. Right now, markets expect a peak Fed Funds rate of 4.5% or a bit higher. If the Fed suggests that is a minimum expectation, more short-term pain can be expected. Beyond that meeting, the focus should shift to third quarter earnings. Overall, they should once again prove the ability of managements to cope with today’s issues.
Today, Jimmy Butler is 33. Florida Governor Ron DeSantis turns 44.
James M. Meyer, CFA 610-260-2220