Equity markets have picked up steam following a lower-than-expected increase in consumer prices during October. With improvement in the trajectory of inflation, interest rates have come down across the curve, and pressure on stock prices has eased. The S&P 500 is up roughly 11% from its low, and some of the year’s worst performers have bounced sharply. Still, it is far too early for the Fed to call mission accomplished on inflation. The labor market remains exceptionally tight, and wage pressures continue to permeate through consumer prices. Inflation won’t be beaten until labor softens. Counterintuitive as it is, the durability of the rally in equities rests on further progress to that end.
The consumer price index increased by 0.4% in October vs. economists’ expectations for an increase of 0.6% on a month-over-month basis. Food and energy prices remained pressured by ongoing geopolitical tension. Core goods inflation continued to moderate with declines in apparel and used car prices. On the services side, medical care prices declined, but rents and transportation service prices continued to increase at a stubbornly high rate. Many expect rents will begin to ease in the coming months, given the weakness in housing and the well-established lag between market rents and CPI data. This would be a welcome development but depends in large part on the trajectory of wages. Higher wages increase demand for housing, but 7% mortgage rates lead many to rent instead of own. As a result, rental demand could remain elevated despite the soft housing market.
Wage pressure emanates from the tight labor market. In the wake of the COVID-19 pandemic, roughly 1.5 million Americans left the labor force with little hope of returning. Today, there are roughly 1.9 job openings for every unemployed person. Demand is simply too high for the level of labor supply available. The result is higher prices via higher wages. The solution is for the Fed to reduce demand with interest rate hikes, but 375 bps of Fed Funds hikes to date have yet to put a dent in demand. They have more work to do.
Going forward, the Fed may slow its pace of hikes. We expect rates to rise 50 more bps in December and at least another 25 bps in January. The cumulative impact of rate hikes is most important. The Fed knows monetary policy acts with a lag and will be cautious about overdoing it. However, this does not mean that further hikes are off the table. Should the next few CPI reports come in hot, we can only expect that the terminal rate will be pushed higher. The Fed has made it clear they will risk a recession to rein in inflation. Progress on inflation is everything for markets. October’s report was a good first step, but it was only that.
Preston May, CBE®
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