Stocks and the Inflation Outlook

The stock market should continue to rally over the next several weeks, as strong corporate earnings pile in.   The S&P 500 is up about 4% so far this year, raising prospects that the outlandish market strength seen in early 1987 is repeated (see my blog of January 8).  A more aggressive Fed is still the main risk to the rally, and the inflation outlook may be a key to foreseeing whether it will diverge from its gradual approach to tightening.   While the stock market appeared to ignore the high 0.3% m/m December Core CPI reported on Friday, it should have "raised eyebrows" that an aggressive Fed may become more than a risk.  I expect fears of the Fed will become more serious after the earnings season is over, in late February or March, and that stocks will trade more cautiously then as a result.

To be sure, the January Core CPI, due February 14, may not significantly change the odds of three Fed rate hikes in 2018 -- the consensus view.  The Core is likely to stay in the 0.2-0.3% range in that report, as housing rent stays firm.  But, the y/y would be 1.7-1.8%, versus 1.8% in December, so the market may take it in stride.  A couple of the components with large gains in November and December (motor vehicles and prescription drugs) may flatten -- as has happened in the past and possibly resulting from bi-monthly sampling, but start-of-year price hikes are typical this month and low post-holiday inventories could lift apparel prices.

The inflation story may become more significant for the markets in the subsequent CPI reports.  This is because the Core CPI may remain in the 0.2-0.3% range in the next few months -- which would push the y/y above 2% in March or April (reports due in April and May, respectively).   The current run-up in oil prices may begin to filter through to some components in the next few months.   Also,  the weaker dollar may begin to lift import prices, although there tends to be a tenuous relationship between the two.   Note that non-auto consumer or capital goods import prices have not moved up through December.  

Wage inflation also is not likely to be of immediate concern, but could develop as a problem ahead.  Calendar considerations point to a modest 0.1% m/m increase in January Average Hourly Earnings, due February 2.  But, the calendar shifts to suggesting a larger 0.3% m/m increase in the February Report, due March 2.   The bonuses and minimum wage hikes announced by some large companies are likely to have a negligible impact on wage data.   Bonus payments do not affect AHE.  Minimum wage hikes on a national scale never have had a noticeable impact on the Employment Cost Index, because the number of workers who receive the minimum wage is very small.   Moreover, since some large companies attributed the bonus and wage hike to "sharing" the corporate tax cut, they presumably would not pass through the higher labor costs to prices.

Inflation may get some attention this coming week with the release of survey data on consumer inflation expectations,   The New York Fed releases its December survey on Tuesday.  One-year inflation expectations were 2.6% while 3-year expectations were 2.8% in both October and November.   The University of Michigan Consumer Inflation Expectations for January come out on Friday.  The 5-year inflation expectations was 2.4% in December.  Note that the longer-term expectations are more important than the one-year expectation for the Fed.  The one-year is likely to be up as a result of higher oil/gasoline prices, which may be temporary.