The markets have rallied to start the year. One reason seems to be that investors are getting comfortable with inflation. It looks like inflation peaked last summer, and it’s been falling ever since.

However, we think it’s a bit too early to assume inflation, and also interest rates, are going to come down for good. The Fed’s preferred inflation metric is starting to fade, but not fast enough.

Today, we’ll cover why the Fed isn’t so keen on taking the foot off the gas.

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Inflation was one of the biggest headwinds facing the market last year. Prices soared for food, energy, cars, and everything in between.

Folks were paying a lot more in their daily lives… and the Federal Reserve stepped in with interest-rate hikes to cool things off.

The central bank raised rates by more than 4% in less than a year. That’s a historically rapid pace in the name of fighting inflation.

Now, the economy seems to be calming down again. Some folks think it means the Fed is close to reversing course.

Those investors are getting ahead of themselves after only a few good months.

As we’ll cover today, the Fed isn’t ready to lower interest rates yet…

That’s because 2023 poses its own set of challenges… and the central bank is being cautious. It’s looking at an entirely different metric before it takes its foot off the gas pedal.

The Fed’s rate-hike campaign is starting to work.

We can see this reflected in the consumer price index (“CPI”). It tracks the change in prices of consumer goods.

The CPI peaked at 9.1% in June… and has been falling ever since. It dropped to 7.7% in October and 7.1% in November. In December, it was 6.5%. So it went down even faster than in prior months.

Investors are getting more optimistic about the future. They hope that if inflation continues to decrease faster than expected, the Fed will ease up on rate hikes.

However, the Fed has its own inflation metric to consider.

Each month, the central bank releases data for what’s called personal consumption expenditures (“PCE”). The PCE is one of its preferred inflation metrics.

While the CPI gets its data from consumers, the PCE gets its data from businesses. It’s usually more accurate than the CPI… at least from the Fed’s perspective.

Like the CPI, recent PCE data from the Fed has shown that inflation is stabilizing. It peaked at more than 6% in the middle of 2022. By November, it had dropped to 5.6%.

Check it out…

The dip in the PCE is a step in the right direction. However, the Fed is being explicit with its messaging…

The central bank recognizes that the economy is heading in the right direction, though it doesn’t think it’s improving fast enough yet.

The Fed tries to keep the PCE around 2%, and it doesn’t think that we’re going to get down to those levels anytime soon.

During a December meeting, policymakers actually increased their inflation forecast for 2023. They now expect inflation at 3.1%, up from their previous 2.8% estimate.

This is largely because unemployment rates are still historically low. When few people are looking for jobs, it can create a bidding war… which leads to higher prices. The technical term for that is “wage-price spiral.”

So the Fed isn’t just keeping an eye on where inflation is headed…

It’s also keeping an eye on the labor market.

In December 2022, the unemployment rate was just 3.5%. That matches the level in 1969, before the 1970s and the “lost decade” of inflation.

Low unemployment persists despite multiple rounds of layoffs from big companies. There may still be tough times ahead…

The Fed wants to weaken the labor market and increase unemployment. That means it’s not going to ease rate hikes anytime soon. During last month’s meeting, it implied that rates could surpass 5% this year unless unemployment rises.

When it does give way, that will push us into a downturn.

The Fed is basically committed to a modest recession. And it’s going to facilitate that within the economy… just not right now. With employment levels so high, a recession isn’t likely until the second half of the year.

With at least another rate hike or two on the horizon, we expect continued rocky roads for the time being… not the strong bounce analysts are hoping for.

So, although the market is rallying to start off 2023, investors need to tread cautiously and temper their expectations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research