What Will Calm The Stock Market?

The stock market may stay under pressure from fears of more aggressive Fed tightening until evidence suggests otherwise. A more aggressive stance could consist of a return to 50 BP hikes or a longer stretch of 25 BP hikes.

The next set of key data begins this week, with the February Chicago PM and Mfg ISM.  Neither is expected to be weak enough to undercut these fears.   They are expected to rebound a bit, but stay below the 50 level.

More important reports will be released in the weeks after, including the February Employment Report (March 10), CPI (March 14) and Retail Sales (March 15).   While the risks are for Payrolls and Retail Sales to slow, it's not clear they will slow enough.  They may have to weaken to a below-trend pace if not an outright decline to calm the market's fear.  Similarly, there are reasons to expect the February Total CPI to slow, but the same factors that boosted the Core in January could persist to some extent in February.   So, stocks may not be out of the woods until there is some word from the Fed about its intentions, possibly as late as the March 21-22 FOMC Meeting, itself.

Maintaining a 25 BP pace of tightening can't be ruled out, nonetheless.  Indeed, on Friday, Cleveland Fed President Mester backed away from being adamant about the need for hiking by 50 BPs.  The Fed may decide that the recent economic strength is temporary, possibly reflecting exaggerated seasonal adjustment or warm winter weather.  Payback in the Spring is possible.   The path to lower inflation could be viewed as uneven.  Fed officials could be counting on a sharp slowdown, if not reversal, in Owners' Equivalent Rent in the second half of the year.  This, by itself, could pull the Core CPI down to a 0.2% m/m (about 2% annualized) pace.  

A period of sustained low inflation, however, most likely requires more labor market slack.  With sufficient slack, possibly meaning a 4.5+% Unemployment Rate, the economy can grow moderately without lifting inflation.  The quickest way to push up the Unemployment Rate is through a recession.  Fed comments suggest this would be the last resort in its fight against inflation.  Instead, they appear to be aiming for an extended period of below-trend economic growth to lift the Rate.  Currently, GDP Growth is above trend, according to the 2.7% (q/q, saar) Atlanta Fed model estimate for Q123.  The Fed estimates trend growth at 1.7-2.0%.   To achieve below-trend growth, a long drawn-out path of 25 BP hikes may be needed.  A pause in tightening could result in a bounce in economic growth, given the resiliency of the US economy -- which in turn could prompt renewed Fed tightening.  Under this uneven scenario, the stock market would likely stay in a wide range until enough labor market slack is achieved.