What Came First, the Market or the Fed?

The hardest part about interpreting the inflation situation is that you can build a case for being optimistic or pessimistic depending on what you focus on. Here’s a summary of the December data released yesterday:

•  Headline CPI +7.0% y/y compared to +6.8% in November.

•  Core CPI (ex-food and energy) +5.5% y/y compared to +4.9% in November.

But…

•  On a month-over-month basis, headline CPI +0.5% compared to +0.8% in November.

That last bullet means it’s slowing, right? And that’s good, right? The stock market seemed to like the numbers (S&P +0.28% yesterday, Nasdaq +0.23%), so it must have been positive, right?

Not so fast. Headline CPI slowed compared to November, but core CPI came in above November’s read. It wasn’t a broad slowing across the board, and the year-over-year number hit 7% for the first time since 1982.

Duck, Duck, Goose

A few months ago, used cars and trucks were the culprit driving most of the increase and we thought we’d be alright as long as those cool off. Fast forward six months — used car prices are rising again, plus we have meaningful increases in energy, food prices, shelter, household furnishings, and medical equipment. Services inflation has also started to pick up (which is where shelter falls), and is generally viewed as more persistent than goods inflation.

Point being, it’s not just a flash in the pan in one spot. There are spots all over this animal. It’s not that I think it’s going to stay this high; I don’t. But I do think it’s going to stay elevated above 2-2.5% for some time. Now it becomes the most delicate walk on a balance beam Jerome Powell will ever take.

Bulls on a Shortened Parade

The first question is whether inflation will cool off enough on its own to not threaten corporate earnings growth or hurt consumer spending. The second question is less about whether the Fed can control inflation expectations with policy moves (spoiler alert, they can), and more about whether the market is going to think they’re making a mistake and create a self-fulfilling prophecy. The Fed is left to react to inflation, but not overreact. Start, but not go too fast. Tighten, but not in the “wrong” ways.

After the last few experiences we’ve had watching the Fed seemingly bend to the market action, I suspect many expect the same this year if things start to go awry. In other words, we’re used to the market leading and the Fed following. I think that leadership flips this year and it will take some getting used to.

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