By Arthur G. Swalley, CIMA, Partner

2nd Quarter 2023

The first half of 2023 was highlighted by a substantial rally in risk assets, despite a mini bank crisis and a year’s worth of negative prognostications about an impending recession. On July 12th, the Bureau of Labor Statistics reported that the consumer price index rose just 3% last month from a year ago, a sign that inflation is cooling quickly. The report marked 12 consecutive months of slowing inflation data, in strong correlation with 10 Federal Reserve rate hikes over the prior 16 months.

So, has the Fed been able to get inflation under control, even without the traditional trade-offs in the form of meaningfully weaker labor markets and economic growth (a recession)? Goldman Sachs Chief Economist Jan Hatzius, in a post-CPI note: “The probability of a U.S. recession has fallen further as both recent data and ongoing fundamentals point to rapid — and mostly painless — disinflation from here.” For the time being the markets are agreeing and pushing towards their January 2022 high water marks. Despite substantially higher interest rates, unemployment remains near record lows, wage growth is strong, and corporate earnings are running ahead of Wall Street estimates.

Therefore, is the Fed finished raising interest rates? Jennifer Lee — senior economist at BMO Capital Markets — says the data gives some “breathing room” for the Fed. Assuming additional inflation reports this summer show a similar trend, “this definitely gives them the justification to remain on the sidelines.”

“The new data could give the Fed reason to debate whether any further rate hikes after this month are needed,” says Ryan Sweet, chief US economist at Oxford Economics. “This tightening cycle by the Fed is likely coming to an end.”

Great expectations, these economists have – reflecting a current reality that is so different than what we were told to expect last year. Fed Chair Jerome Powell’s framework for thinking about inflation, which he first

detailed in a Brookings Institution speech in November 2022, highlighted four key developments in the economic data he needed to know that the Fed had done enough to tame inflation:

• Goods prices should exert downward pressure on overall inflation
• Forward-looking market-based measures of housing inflation should continue to cool
• Non-housing core services — including health care, education and hospitality — should cool. Since those sectors are so sensitive to labor costs, wage growth needs to slow
• The US should have a “sustained period” of below-trend GDP growth

The reality is that only half of these developments in the data have come to pass. Slowing wage growth and below-trend GDP growth may be coming. Is it wise to assume we have a good idea what will happen next in the Fed’s fight against inflation? History tells us no, recalling an old Wall Street joke: “Economists have correctly predicted 9 of the last 2 recessions.”

On a positive note, the trend towards stabilization of prices is helping improve consumers’ attitudes, as reflected by July 17th’s very strong University of Michigan Consumer Sentiment Index reading. The fear and negativity surrounding the economy over the past year is finally being forced out of the dominant media narratives by the overwhelmingly positive data. Of course, there’s a danger that both consumer and investor sentiment could get too good, allowing companies to continue raising prices and keeping inflation higher than the Fed’s 2% target. We think that’s a risk that we should be happy to live with, because US consumers and investors should be much less likely to talk themselves into a downturn. After 3 years of negativity around a global pandemic, toxic politics, war, and higher interest rates, we warmly welcome a shift to positive psychology!