Excessive Fear of the Fed?

The stock market's concerns about the path of Fed policy could be exacerbated by this week's US economic data, as consensus looks for a high January CPI, Retail Sales and Manufacturing Output component of Industrial Production.  But, these concerns are excessive, since the Fed's new gradual approach to tightening should not be derailed by one month's data -- particularly for January, a month when start-of-year effects could dominate.  This consideration applies to the January Employment Report, as well.

Consensus looks for +0.4% m/m for both Total and Core CPI, higher than the Q422 averages (+0.3% m/m for both Total and Core).   The Total risks printing above consensus, while the Core's risks may be balanced.  A big uncertainty for Total is the extent to which the collapse of natural gas prices is captured in the CPI this month.  There is an irony in the drop of natural gas prices.  It will add to the Core CPI in coming months, since natural gas prices are subtracted from Primary Rent in calculating Owners' Equivalent Rent (OER).  So, a smaller subtraction will raise OER relative to Primary Rent.

Consensus also looks for strong January Retail Sales, with Total up 1.5% m/m and Ex Auto up 0.7%.  But, these gains would follow soft prints for November and December, suggesting that the latter two were just the typical pause after a strong month (October).  Despite the m/m volatility, Real Consumer Spending Growth has been steady, in the 2.0-2.3% (q/q, saar) range in the past 3 quarters.  So, while softer prints in February and March are likely if January is strong, the trend should be moderate.

Early evidence suggests that both Payrolls and the CPI will slow in February, as well.  Initial and Continuing Claims are above their January average in the latest week.  And Retail Gasoline Prices have flattened out in early February.  They are still above the January average, but the m/m increase so far is smaller than in January.  Longer-term inflation expectations appear to remain in check.  The 5-year inflation expectations reported in the University of Michigan Consumer Sentiment stayed at 2.9% in mid-February.  

The stock market should view the gradual approach of Fed policy positively, even if the rate hikes persist into the Spring.   A modest pace of tightening increases the odds that the economy will slow without falling into recession.  It shows that the Fed is not ignoring growth while focusing on fighting inflation.  This, in turn, means that the financial markets should not tighten so much as to precipitate a downturn in economic activity, based on the idea that the markets move in ways to achieve the Fed's targets.

Even without a slowdown, the increases in labor and commodity costs should force companies to make cost-saving adjustments.   This may be behind the recent large layoff announcements.  An interesting possibility relates to restaurants.   Higher wages and food prices have boosted meal prices at restaurants.  A broad-based shift to home cooking in response could prompt restaurants to reduce labor costs by becoming more efficient.  The alternative could be to go out of business.  In either case, the recent surge in restaurant jobs may soon come to an end.  Shifts like this are occurring already.  Consumers are reported to have shifted from buying higher-priced brand-named foods to lower-priced store-branded foods at supermarkets.  Generally, labor-/commodity-intensive industries are at a competitive disadvantage.  Market forces precipitated by the run-up in wages and commodity prices, even without slower growth, will push them in ways to cut costs and thereby hold down prices.