Fear of the Fed

Besides fear of the Omicron variation of the virus, stocks may continue to grapple with the implications of the Fed's (and other central banks') increased emphasis on targeting inflation.  While there are some reasons to expect the currently high inflation to abate at some point, a sustained ratcheting down requires a slowdown in economic growth to the near-2% long-run trend -- given the already low unemployment rate.  The larger the extent of slowdown in H122, the less there will be to fear aggressive Fed tightening.

At this point, a GDP slowdown in Q122 is highly likely after its rebound in Q421.  The Atlanta Fed model estimates the latter to be 7.0% (q/q, saar), similar to the 6.9% implied by the Fed's Central Tendency forecast.  Part of the Q421 strength is just a bounce-back from the virus-impacted 2.1% Q321 pace.  This should not carry  into Q122.   Moreover, the boost to consumption from fiscal transfer payments already has begun to abate.  But, the issue is how much of a slowdown will occur.  Early evidence suggests a speedup in December Payrolls -- in the wrong direction if looking for a slowdown.  But, what will be more important is whether Initial and Continuing Claims stop falling.  Their flattening would signal a steadiness in the unemployment rate, which, in turn, would signal near-trend GDP growth.

Inflation may stay high in the next couple of months, but then could turn lower -- independently of economic growth.  /1/ Seasonals look to offset holiday discounting in December and post-holiday promotions in January.  This price cutting likely happened to a smaller extent than seasonals expect because of the supply problems.  So, seasonals risk boosting components like apparel in the next two CPI reports.  But, then seasonals look to offset the ending of this discounting by pulling down prices.  And, since this discounting was likely small, so should the rebound -- so seasonals should depress these prices in the CPI.  /2/ Start-of year price hikes could boost the January CPI -- one-off price increases.  /3/ The stabilization of oil prices may soon help to hold down transportation costs, which could be reflected in the prices of many products (and airfares).  /4/ Motor vehicle prices -- both for new and used vehicles -- could come down once the chip shortage abates.  But, this development seems well ahead in the future.  The November Industrial Production Report showed only a slight increase in motor vehicle production, so the chip shortage is still significant.  Used Car Prices continued to rise in first half of December, according to the Manheim Survey.

Some of these factors may help explain the combination of above-trend growth and slower inflation seen in the Fed's Central Tendency forecasts for 2022.  The Fed looks for 3.6-4.5% Real GDP Growth and 2.2-3.0% PCE Deflator Inflation.  Its forecast of a decline in the Unemployment Rate to 3.4-3.7% (consistent with the above-trend GDP forecast) should be accompanied by faster inflation unless there are non-economic factors holding it down.  Whether the non-economic factors will hold down inflation prints will be clearer by early Spring.  This will be after the Fed's asset purchases end and the markets become even more focused on whether the Fed has to hike by more than 3 times in 2022.  If inflation does not come down by then of if economic growth does not slow sharply, the Fed may have to aim for slower growth than what was behind its 3-hike projection.