Fed Officials Attempt to Cool Irrational Exuberance for Fed Pivot

With a slow Thanksgiving week just ahead, investors had their hands full this week contending with a series of key economic reports and a parade of Fed official speeches. Tuesday’s producer price report confirmed the softening trend in inflation seen in last week’s CPI report. This initially launched markets higher on the belief that “peak inflation” has now passed. Wednesday brought added optimism when retail sales posted a surprisingly strong print as shoppers got an early start to the holiday shopping season and as diners continued frequenting their local establishments. Even a weak home sales report failed to dent investors’ attitudes despite sales declining for the ninth straight month. Last week’s strong rally prompted numerous Fed officials to emphasize in their speeches this week the necessity for the Fed to maintain a prolonged restrictive posture even though progress appears to have been made on the inflation front. While the remarks took some of the shine off the bulls’ “pivot” case, their comments probably failed to achieve their intended effect with the Dow little changed on the week.     

Producer Prices Chill

Producer prices cooled for the second straight month, adding to signs we have seen the peak in inflationary pressures. The producer price index, which generally reflects supply conditions in the economy, rose 8.00% in October from the year ago period. That’s down from September’s revised 8.40% increase and down sharply from the March peak of 11.70%. The March peak was the highest since records began in 2010. On a monthly basis, PPI increased 0.20% in October, matching September’s 0.20% rise. Core prices, which exclude food, energy, and supplier margins, rose 0.2% in October from a month earlier, down from a revised 0.3% in September. On a 12-month basis, core PPI eased to 5.4%, down from 5.6% in both September and August. October’s report reflected a broad-based slowdown in gains for goods prices, with declines for passenger cars and household furniture reflecting improvement in supply chains while higher interest rates reduced demand for household goods. Big buyers, like Walmart, cancelling orders, resisting price increases, and asking for discounts also helped push prices lower during the month. Overall, it was good to see producer prices continuing to ease during the month. However, at an annualized 8.00%, producer prices still remain elevated and should keep the Fed’s restrictive monetary policy firmly in place.

A Tale of Two Consumers

It has been widely expected that the Fed’s tightening would ultimately take a toll on consumer demand, however, retail sales got an unexpected boost from Mother Nature in October. Hurricane Ian disaster preparation and remediation, along with a spending surge from mid and high-income households, managed to offset weakness from lower income households. Retail sales rose 1.30% in October compared to a flat reading in September. Core retail sales, which exclude gasoline, food, autos, and building materials, rose a robust 0.70% during the month. The figure got strong lift from demand for cars, up 1.50% as consumers replaced an estimated 70,000 vehicles due to damage from Hurricane Ian. Consumers also got a jump on the holiday shopping season, taking advantage of early discounts retailers were offering to clear out inventory ahead of the holiday season. Ecommerce sales rose 1.20%, driven by Amazon’s Prime Day in October and competing retail sales events. Socializing remained popular during the month with sales at restaurants and bars up 1.60%. Much of the retail sales growth has been driven by demand from higher income households while it was formerly being driven by lower income households. According to Bank of America, lower income households contributed just one fifth of the growth in discretionary spending, compared with around two fifths back in October 2021. Lower income households are the most negatively impacted by inflation, which is something the Fed is acutely aware of and yet another reason to believe they will remain restrictive until they are sure they have snuffed inflationary pressures. 

Fed Hikes Put the Housing Market on Ice

High mortgage rates and tight inventory continued to hit the housing market in October. Existing home sales slipped for the ninth straight month, falling -5.9%. That is the slowest pace since December 2011, with the exception of a brief drop at the beginning of the Covid pandemic. Inventories remained tight with just 1.22 million homes for sale at the end of October, down 1.00% both month-to-month and year-over-year. At the current level, that reflects a 3.3-month supply. Historically, a balanced market is considered to be a six- to seven-month supply. Tight supply also means higher prices with the price of an existing home sold in October rising 6.60% year over year to $379,100. However, prices look set to trend lower as the Fed’s hikes have pushed up mortgage rates to 7.00%. Normally, you’d think higher interest rates would reduce demand and make this more of a buyer’s market, but the extremely tight supply has offset that trend by continuing to support prices and keeping this a seller’s market.  

Final Thoughts

This week’s final thoughts are virtually identical to those we shared last week – but validated by the fact the Fed took to the airwaves this week cautioning markets that a pivot is not likely to occur as soon as expected. The Fed is not done, and the terminal Fed funds level is likely to exceed what the market is expecting. Inflation data, while cooling, is not cool and in fact is still quite hot in some areas. The market has applauded the deceleration in price increases seen in the CPI and again in the PPI reading this week, but it is choosing to ignore many of the demand factors positively influencing inflation which continue to remain strong. The proof for that lies in this week’s retail sales figures, which were strong, and labor market readings, where this week’s weekly jobless claims continue to hover around the low end of average. One must believe Jerome Powell is entirely bewildered or infuriated by the market’s reaction lately because the wealth effect complicates the Fed’s job. Greater wealth leads to greater spending, which can lead to greater inflation and the Fed needing to raise rates even higher. Markets almost always overreact in the short-run and sadly, the market’s response to a potential pivot may be the very thing that prevents the Fed from actually doing so.

The Week Ahead

It’s hard to believe the Thanksgiving holiday is here! In observance, the next edition of our market commentary will be published on December 2^nd with the latest nonfarm payroll figures and global manufacturing numbers.