Fed Shifts Back To Role as Inflation Cop

The Federal Reserve raised its benchmark lending rate by 0.25% on Wednesday, bringing the current, federal-funds benchmark range to 0.25% to 0.50%. The move has been a long time in the making and for markets, the hardest part has been in the waiting – knowing that rates need to rise but concerned about an overly aggressive tact. The Fed noted strong economic growth coupled with a healthy labor market as their primary motives in moving from an accommodative rate to what they hope will be a neutral rate environment, but with inflation at the top of everyone’s mind, officials penciled in six more rate hikes in 2022. If the forecast holds, that will bring the federal funds rate to 1.90% by year-end. For 2023 and 2024, the Fed expects the fed-funds rate to settle at 2.80% as demand imbalances related to the pandemic and high energy prices are resolved. It should be noted that these projections are significantly higher than they were just in December, showing just how fluid their policy remains. The Fed left itself some wiggle room to take a more aggressive stance if commodities prices continue to move higher on the Russia-Ukraine conflict. Fed Chairman Powell indicated rates could rise by a half percentage point later this year if inflation remains high. 

 

Consumers tapped the brakes on retail spending in February after a January buying spree. Retail sales rose 0.30% in February to $658.1 billion. That was well below January’s 4.90% rate. Excluding autos, sales were up 0.20% month-to-month. Online shopping took the biggest hit, down -3.70% for the month. Health and personal care and furniture store sales also fell, down -1.80% and -1.00%, respectively. Given supply constraints, it was no surprise that gas store sales led the month’s gains, up 5.30%. Bars and restaurants saw sales rise 2.50% as diners returned to their favorite establishments amid a drop in Omicron cases. It’s too early to tell if the modest February gains indicate a pivot in consumer spending amid high inflation or just a break from strong January buying. March numbers should provide more clarity to consumer psyche as they will include the impact of even higher gasoline prices due to the Russia-Ukraine conflict and vacationers on Spring Break.

 

The only positive news in this week’s producer price index reading was that it was not as bad as January’s report. The price of producers’ final goods and services rose 0.8% for the month or a whopping 10% annualized rate in February. This is down from January’s 1.2% (approximately 15% annualized) rate, but still painful when you consider that the PPI over the past twelve months (ending February) has actually risen 10% and is still pacing at 10% annualized. The PPI increase was almost entirely felt on the goods side of the economy and not so much on the services side. The rising cost of wholesale gasoline and energy were major components in February’s PPI overall reading. Those subcomponents rose 14.80% and 8.2% for the month, respectively. The increased energy costs pushed goods prices up 2.40% for the month, their largest gain since December 2009, while services prices remained unchanged. Adjusting for core prices, by excluding food, energy, and trade services, overall PPI still rose 6.60% from year ago levels. February’s PPI report was another tough reading, which helps explain why the market may have applauded this week’s rate increase.

 

We entered the year with conditions that were very constructive for markets. Consumer balance sheets were strong. We had high personal savings reserves to fuel consumption, and most expectations were that 2022 would be another solid year of GDP growth. The Fed had the challenge of raising rates while not stalling the economy in the process, but that was within the context of the Fed having a large buffer to work with. Starting in February, however, the issues just started to pile up. Inflation, which had been considered transitory, remained sticky and started broadening once the pandemic receded and economies reopened. The tight labor market got tighter, and wage-price spiral indicators began to accelerate. Then the war in Ukraine sparked not only existential concerns that have weighed on sentiment but also brought into play new mechanical factors that have fanned inflation, particularly with respect to commodities and energy. Understandably, investors had gotten a little white-knuckled over the past five weeks, which makes their reaction to this week’s news somewhat paradoxical. This week we had sharply lower existing home sales (-7.2% month-to-month, -2.4% year-over-year), high PPI inflation readings (see above), lower jobless claims and the Fed topped it off by raising rates. On the face of it, none of these should have been reason for the market to rally, but where it may have worried about higher rates damaging economic growth at the beginning of the year, the market has now come to see inflation as the greater threat. This week, the combination of falling oil prices, which directly cools prices, along with the Fed taking explicit action by raising rates to dampen demand, helped bolster investors’ confidence that the Fed was finally back on the inflation beat after a three-year hiatus.