Fed Downshifting Versus Risk of Recession

The stock market will likely continue to contend with the risk of recession, but the possibility of a further downshifting in Fed rate hikes to 25 BPs from 50 BPs may very well win out. 

Fed Vice Chair Brainard's speech last week spells out how inflation can be beaten without necessarily a recession.   It also reiterated that interest rates would remain at restrictive levels for an extended time, although did not mention how much further or how fast they will climb from here.  But, her analysis, described below, suggests that not much more tightening will be needed.  So, the door remains open for another downshift in Fed rate hikes at the January 31-February 1 FOMC Meeting, particularly since other Fed officials appear to be favoring a 25 BP hike. 

Brainard expects the US economy to slow further this year, as the lagged impact of last year's tighter monetary policy takes hold.  The labor market already is beginning to cool, as she cites the declines in the Nonfarm Workweek, Temporary Help Services and Payroll Growth.  Also, the labor force has been constrained by the extraordinary increase in retirements and the impact of long-COVID symptoms.  And, immigration has been low.  

She also saw reasons for a slowdown in inflation without a recession.  Softening import prices,  easing supply constraints, inventory rebuilding and weaker demand has lowered Core Goods Inflation.  Slowdowns in wage rates and other factors could continue to help slow Non-Housing Services Inflation.  And, Housing Services Prices should begin to reflect the declines in new leases by the summer.  Finally, longer-run inflation expectations appear to be well-anchored.  

Last week's US economic data did not resolve the question of recession or slowdown in 2023.  Weakness in December Retail Sales and Industrial Production keep open the possibility of recession.  But, other data were not as weak.  The January Phil Fed Mfg Survey's components suggest a stabilization in the manufacturing sector, although the overall Index remained negative.  December Housing Starts fell, but the decline was in the volatile Multi-Family Units.  1-Family Starts rose.  And, the Claims data remained low, not rebounding from the low prints in the prior two holiday weeks.  These data suggest a speedup in January Payrolls.

Next week's US economic data also may not resolve the recession/slowdown debate.  Consensus looks for another decline in the Leading Indicators, raising the possibility of a recession in early 2023 according to the Conference Board.  But, December Durable Goods Orders are seen rebounding and Consumer Spending slipping only 0.1% m/m -- less of a decline than seen in Retail Sales.  Consensus expects the first-print of Q422 Real GDP to be up 2.6%.  This is below the Atlanta Fed model's 3.5% estimate.  While both are above trend, an in-line print could be viewed as "history" by the markets.  The December Core PCE Deflator is seen at +0.3% m/m, the same as the Core CPI.