Stocks stalled this week after several economic indicators showed a strong economy. Payrolls increased, the average workweek rose, and average hourly earnings rose, indicating that the labor market remains strong. Meanwhile, retail sales jumped 3% month over month in January and auto sales jumped to 16.2 million units (saar) from 13.6 million in December, indicating that Americans are still doing what Americans do best – spending! So far, the long-awaited recession seems to be missing in action.
To understand the current stock market environment, it is important to remember that inflation remains investor’s primary concern. While good economic data would normally boost stocks, investors are more concerned that good economic data will force the Federal Reserve to hike rates further to get inflation under control. January’s Consumer Price Inflation, released on Tuesday, was 6.4%, which was down from 6.5% in December, but still higher than the market had hoped. Prices in goods are abating but prices in services are still stubbornly high.
On Thursday, in response to the recent data, two of the non-voting members of the Federal Open Market Committee (Bullard & Mester) suggested that interest rates will need to go higher and stay higher longer than previously recommended. Will the Federal Reserve be able to bring down inflation without causing a recession? Some argue that the answer is no; that it is impossible to reign-in inflation without a recession, resetting consumer expectations. In this way of thinking, a recession is inevitable since rates will continue to rise until there is a recession. Others point to already falling inflation and argue that higher interest rates are already having an impact, and are still rippling through the economy. In this way of thinking, inflation can recede, given enough time, without a major recession.
The bottom line is that we continue to be in a high risk environment. The risk of a policy error is high as the Federal Reserve attempts to bring down inflation without causing a recession. As we have discussed previously, there is a ‘ditch on both sides of the path’. The Federal Reserve is attempting to stay on the path of bringing down inflation without causing a severe recession. If the Federal Reserve raises raise too little, we risk falling into the inflation ditch where inflation continues to rage out of control. If the Federal Reserve raises rates too much, we risk falling into the recession ditch where we face a severe recession. This most recent data appears to argue for higher interest rates as we see our way forward.