KEY DATA:  Real Consumption: +1.5%; Real Disposable Income: -0.5%; Inflation: +0.6%; Ex-Food and Energy: +0.5%/ Orders: +1.6%; Private Capital Spending: +0.9%/ Pending Sales: -5.7%/ Sentiment: -4.4 points

IN A NUTSHELL: “Consumers may still be spending money, but with incomes being eaten away by inflation and confidence falling, a slowdown should be expected.”

WHAT IT MEANS:  This economy has a lot of staying power.  At least through January, households continued to empty their wallets, spending like crazy. Consumption surged, rising much more than expected.  Demand for durables skyrocketed, after having declined sharply in December.  There was a large rise in nondurables demand and a more restrained, but still solid increase in purchases of services.  Even adjusting for inflation, real total consumer spending was up significantly, but it is not clear those high spending levels can be sustained.  Disposable income rose minimally in January but adjusting for inflation it dropped like a rock.  The government’s ending of some stimulus programs continues to reduce income sharply.  The savings rate declined to its lowest level since December 2013.  And there is little reason to think the large price increases we saw again in January will fade quickly. Energy costs were already high, and the Russian invasion may exacerbate the problem.  The global supply chain is untangling, but it is still a mess, just less so. The supply of homes is largely nonexistent, so housing prices should continue to rise.  And corporate pricing power remains in place.  At the same time, consumer confidence continues to fall.  In other words, all indicators point to slower consumption in the months ahead.   

Businesses are also spending like mad.  Durable goods orders jumped in January, even when removing volatile aircraft orders.  The measure of investment activity, private nondefense capital expenditures, rose sharply.  Companies are betting on the future.  Given their ability to raise prices and maintain earnings, that makes sense.  But again, if household spending power continues to fade, so should demand, which raises questions about future investment. 

Consumers, facing all the issues that are out there, are getting pretty upset.  The University of Michigan’s Consumer Sentiment Index declined again in February, with both the current conditions and expectations indices nosediving.  The level is the lowest in over ten years.  The measure did pick up in the second half of February, but with the Russian invasion and further increases in gasoline prices in the offing, I would not be surprised to see another drop in confidence in March.

Can home sales remain strong in the face of rising prices and interest rates?  That is not clear.  The National Association of Realtors’ Pending Home Sale Index, a measure of future sales, fell in January for the third consecutive month.  Only the West posted a rise, but that was nothing special.  With rates and prices up, you would expect demand to fade.  But currently, the historically low level of inventory makes it unclear whether the issue is demand or supply.

IMPLICATIONS:  That was then, and this is now.  The economy did quite well in January, but the indicators are concerning.  Household spending power, measured by inflation-adjusted disposable income, is going in the wrong direction.  Workers may be getting big pay increases, but the goods they are buying are costing even more.  That cannot be good news for future demand, especially since the factors driving up prices are mostly still in place.  Though the invasion of Ukraine may not resonate with everyone, any impacts it has on energy costs will.  The markets seem to think that the sanctions on Russia, which were designed to limit the impact on energy costs, will likely do just that.  Oil and gas prices declined today.  But we are just in stage one of the battle and while the military outcome was never really in doubt, what comes next is.  The direction of energy costs remains uncertain, with the risk still to the upside.  If the sanctions have the potential that the President claims, then as he mentioned, we need to wait a month to see how deeply they hurt Russia and its trading partners.  There is nothing good that can come from the invasion in the short-term.  In the mid-term, if it causes Europe to wean itself from its dependence on Russian energy, then something positive may happen, though at a massive cost to the Ukrainian nation.

KEY DATA:  Home Sales: -4.5%; Prices (Over-Year): +13.4%/ CFNAI: +0.62 points/ GDP: 7% (from 6.9%)/ Claims: -17,000

IN A NUTSHELL: “The economy was doing just fine in January, but the Russian invasion of Ukraine could have a real impact on world growth.”

WHAT IT MEANS: Whatever data came out today have been overwhelmed by world events, but let’s start with them as they tell us where the economy was before the shooting started.  New home sales fell in January, but that was not a surprise.  Cold weather, a lack of inventory and a surprisingly strong December combined to reduce total sales.  Demand eased in three of the four regions, with only the West posting a gain, which was modest.  Looking at prices, they rebounded sharply from the December drop and are nearing the high set in October.  Over the year, price gains are robust, but nowhere near the 20% or more increases seen in the second half of last year.

Chicago Fed’s National Activity Index, a composite of 85 indicators, jumped in January.  Each of the four indicator groupings rose, pointing to a broad-based improvement in activity.  Other measures, such as the three-month moving average, also indicated that we should see continued solid economic growth.

Fourth quarter 2021 economic growth was revised upward slightly.  The GDP inflation rate was revised upward, though the overall personal consumption price measure was revised downward. Regardless, the inflation rates were the highest since the wage-price inflation of the late 1970s-early 1980s.  There is growing fear they could be just as elevated this quarter, given the potential impacts of the Russian invasion of Ukraine.  Growth this quarter is likely to be modest, as the massive inventory rebuild we saw in the fourth quarter will not be matched at all this quarter.  Inventories could take four percentage points or even more out of growth.

Jobless claims fell again last week, and the level is getting close to what we should see for the remainder of the current expansion. The labor market is tight and getting tighter.

INITIAL THOUGHTS ON THE RUSSIAN INVASION’S ECONOMIC IMPLICATIONS: The Russian invasion of Ukraine changes an awful lot of things.  By how much? Who knows?  We don’ know what is Putin’s end-game?  We don’t know yet what actions the U.S. and its allies will take.  We don’t know what the oil producers, especially Saudi Arabia and Kuwait, will do if energy becomes a weapon for both sides. The U.S. is less exposed to Russia than Europe, but Putin appears willing to pull out the stops to match any sanctions imposed on Russia.  Will Europe and the U.S. be willing to pay the price of strong actions?  It’s unclear, but there are few politicians who are willing to be called the new Neville Chamberlain.  There is also the issue of China.  As of now, the Chinese have yet to take a stand against the invasion. They are not even calling it an invasion, which is hardly surprising.  Anything that weakens U.S. primacy helps China, at least that appears to be their strategy.  That approach is likely to impact U.S./China relations.  This is a political year, and you can be sure that anything but China opposing the invasion is going to lead to Senators and Representatives campaigning against China.  Those politicians are likely to be on both sides and numerous. Will that vilification matter?  It has to, but it is hard to say how. There will also be longer-term economic impacts. Europe (Germany in particular) is already re-thinking its relationship with Russia, especially when it comes to energy.  That presents an opportunity and challenge to the U.S. to supply Europe with energy products.  It is also likely to accelerate the movement to renewable energy sources that delink energy-importer nations from those that export carbon-based products.  The Russian military action reinforces the basic concept that supply chains need to be as diverse as possible.  Competition is good, but too many firms forgot that it includes competition between nations in providing goods and services, not just companies.  That was a lesson learned from the pandemic and the supply chain problems that emerged, and hopefully that lesson is being pounded into the minds of leaders of nations and companies once again.

KEY DATA:  CPI: +0.6%; Over-Year: +7.5%; Ex-Food and Energy: +0.6%; Over-Year: +6%/ Real Earnings: +0.1%; Over-Year: -1.7%/ Claims: -16,000

IN A NUTSHELL: “If the Fed members think slow but steady will win the inflation race, they are living in a fairy tale.”

WHAT IT MEANS:  Another report, another clear sign that inflation is not going away easily. This time it is the Consumer Price Index, which surged again in January.  This was not a surprise, though the monthly increase was a touch higher than the forecasts.  I think economists cannot believe inflation is still running this hot, but we will adapt, eventually.  The January report was not very pretty.  Food and energy prices surged, but even excluding those categories, household prices rose sharply.  Gasoline and gas prices dropped, but those declines should be reversed in the February report.  Otherwise, prices were up across the board.  If you eat out, you know how much prices have risen already, and the increases are still coming.  Most distressingly, donut prices are surging once again, after having eased in December.  I did get my last box of Entenmann’s chocolate covered donuts at half price, though.  On a more serious note, the increase over-the-year was the highest since February 1982.  That was when Paul Volcker was unwinding his nuking of the economy.  That’s something to think about.

Workers may be benefitting greatly on paper from their huge wage increases, but when it comes to their purchasing power, they are losing ground.  The jump in consumer prices almost totally offset their wage gains in January.  Over the year, they lost a lot of ground.  And with hours worked declining, weekly wages plummeted.  They are down over 3% since January 2021.  That is not good news for the economy.

As for the labor market, it remains the same – tight as a drum.  New claims for unemployment compensation fell again last week and it looks like the surge we saw in January was just a blip in the data.  Backing that up was the Conference Board’s Help Wanted OnLine January report, that was released yesterday.  It inched down, but remained near record highs. 

IMPLICATIONS:Clearly, the Fed members believe that fairy tales can come true, that they can happen to them, because they are – young at heart?  Really?  I know, I am being harsh, but that is what I heard when I called the Fed a band of clueless inflation fighters for much of last year.  I believe the FOMC needs to make a statement at the March meeting.  Yes, I am being a broken record, which is an unfortunate tendency. However, the Fed members have been signaling that a 25-basis point hike is enough to show they are on top of things, and I don’t agree.  I understand that the Fed is an oil tanker that takes forever to change direction, but that means you must start sooner and act strongly to make the turn on time.  It seems like the members have abandoned the transitory verbiage but not accepted the concept that an alternative is lasting or enduring. Measures of inflation expectations have remained at or above 4% since last spring.  We saw similar periods where they stayed above 4% for six months or more in the late 1970s/early1980s, the late 1980s and in 2008.  Each time it took a recession, usually created by large Fed rate hikes, to rid the economy of those beliefs that future price increases will remain elevated.  The current Fed knows this history and doesn’t want to repeat it.  But starting off with a sharp rate hike doesn’t necessarily mean future rate hikes have to be just as large.  If it changes perceptions that the Fed is going to be consistently behind the curve to the Fed is getting out ahead of things, then the FOMC can back off on the size or increase the time between hikes.  Being the tortoise may have worked in an Aesop fable, but this is the real world.

KEY DATA: Deficit: $1.4 billion wider; Exports: +1.5%; Imports: +1.6%/ NFIB: -1.8 points

IN A NUTSHELL: “The U.S. economy may have recovered sharply in 2021, but a lot of the improvement was used to buy foreign products.”

WHAT IT MEANS:  The world economy is coming around, as Omicron starts to burn itself out and restrictions are eased.  That is the good news.  The bad news is that the U.S. continues to ship its recovery out to the rest of the world.  In December, the monthly trade deficit widened again, reaching a record high.  Records are nice, but not this one, as it represents growing funds flowing out of the country.  Much of that income went to China, as our exports to that country declined but our imports soared.  Both export and imports increased in December, which is what we want to see.  We sold more of just about everything to the rest of the world.  Only food exports declined, with soybean sales leading the way.  As for imports, our demand for consumer goods, especially cell phones, vehicles and capital goods jumped.  Our purchases of industrial products (largely petroleum) as well as food were down.  For all of 2021, the deficit widened by $182.4 billion, or twenty-seven percent.  That should put into perspective the magnitude of the widening of the deficit. 

Small businesses optimism, not surprisingly, continues to falter.  The National Federation of Independent Businesses’ Index fell in January and the level is not too far from where it was in March 2020.  Firms continue to be battered by rising input and labor costs and a shortage of qualified workers. The report noted that: “The net percent of owners raising average selling prices increased 4 points to a net 61 percent seasonally adjusted, the highest reading since Q4 1974.”  Can you say inflation?  The respondents don’t think this is a very good time to expand, largely because of the rising costs of doing business.   

IMPLICATIONS: There wasn’t a lot of good news in today’s data.  Yes, we are selling more abroad, but we are also shipping a lot more of the income that has been generated by the recovery out of the country.  That is slowing growth and there is little reason to expect that to change.  On the inflation front, when there is a record share of small businesses saying they are raising prices, that is a clear indication that inflationary pressures have spread across the economy.  I have noted several times that the rate of inflation will ease as we go through this year.  The growing numbers of firms of all sizes raising prices is a warning that pricing power may be starting to become embedded in the economy.  And once firms know they can raise prices, they are likely to hold onto that power as long as possible.  The Fed will soon embark on the process of raising rates.  The members seem to be signaling that the hikes may not be aggressive, at least to start.  I have argued that the inflation risks are great enough that it would make sense to raise rates not just by one-quarter percent, but by one-half percent to start off.  Economists have started a forecasting war, trying to see who can come up with the highest increase this year.  The latest I have seen is for seven, yes seven 25-basis points increases, for a total of 1.75 percentage points in 2022.  My view is that by coming out with a higher-than-expected initial rate hike, the FOMC might be able to send a message that it means businesses, buying itself some time.  Instead, we could see a repeat of the “slow but steady wins the race” approach.  That could lead to a greater than necessary ultimate increase in rates, as it allows households and businesses to plan for the slow increases and adjust accordingly, forcing the Fed to keep hiking rates.  The Fed needs more of a hammer than a fly swatter approach. 

KEY DATA:  ADP: -301,000; Manufacturing: -21,000; Leisure and Hospitality: -154,000; Small: -144,000

IN A NUTSHELL: “Friday’s jobs report could be more volatile than expected.”

WHAT IT MEANS:  The first major reading of the 2022 labor market comes out on Friday.  The government’s report is previewed by the ADP estimate of private sector payroll changes,  which is forecasting a major drop in employment.  Should we be worried?  No.  Consider that the ADP December estimate was for payrolls to rise by 807,000 (revised to 776,000), but BLS said “only” 199,000 positions were added.  We really shouldn’t look at the monthly ADP numbers.  Instead, I tend to look at an average, and the 237,000 two-month average of ADP’s payroll changes may be right on target.  That is moderate growth and smooths out the widely volatile individual sector numbers.  For example, ADP had manufacturing hiring lots of employees in December but cutting workers in January.  The two-month average is +24,000, which looks like a reasonable trend.  Similarly, should we really believe that restaurants and hotels cut back their workforces massively in January after having bulked up in December?  Not really.  The two-month average of +43,000 may be a little light, but within reason given the way this sector tends to grow in a more normal economy.  Finally, small businesses were the leaders in cutting workers.  That is a bit surprising as the December NFIB Small Business Economic Trends report didn’t point to a major hiring cut back.   

IMPLICATIONS:  I don’t expect a negative employment number to print on Friday.  It looks like hiring and spending are starting to settle down to more typical growth rates.  Yesterday, the Job Openings and Labor Turnover report showed that openings continued to climb in December, though hirings and separations slowed a touch.  That doesn’t mean payrolls are falling, only that they are rising less rapidly.  Indeed, with demand for workers still robust, it is hard to argue that hiring would suddenly fall off the cliff.  Why the ADP report has shown such huge swings is unclear.  Their seasonal factors could be off, which would not be a surprise given that the way the economy closed and reopened had little to do with seasonality.  But the ADP numbers have, over time, tracked the governments data well, so the averaging/smoothing process may be the way to look at a lot of the numbers.  I have employment up in January by about 225,000. which is a somewhat above consensus, which is closer to 150,000.  I am an outlier when it comes to the unemployment rate.  My expectation is that the labor force may be rising faster than expected, and I wouldn’t be surprised if the unemployment rate ticks up to 4%.  That is still at full-employment and would not signal any softening in the labor market.  The labor market is still in very good shape, regardless of what numbers print, and that points to continued solid wage increases as well.    

KEY DATA:  Confidence: -1.4 points; Expectations: -4.6 points/ Phila Fed (NonMan.): -33.5 points/ Case-Shiller Home Prices: +0.9%; Over-Year: 18.8%/ FHFA:  +1.1%; Over-Year: +17.5%

IN A NUTSHELL: “With problems domestically and internationally, it is no surprise that households are getting concerned about the future.”

WHAT IT MEANS:  Let’s see now: The Fed is planning on raising interest rates, consumer and business costs continue to surge, and the equity markets are moving into correction range.  Oh, and there is Putin thinking we are still in the midst of the Cold War, with a potential hot war thrown in for good measure.  What me worry?  I am beginning to wonder if my Alfred E. Neuman attitude should be revisited.  And with the Fed starting its two-day FOMC meeting today, it will be interesting to see if the members start rethinking their views on policy.  The data are not helping either. 

The Conference Board’s Consumer Confidence fell modestly in January, but the details do contain a warning.  The view on the present shape of the economy was up, which was somewhat of a surprise given the data have been hinting at a moderation in growth.  But expectations dropped fairly sharply.  This component can be susceptible to big ups and downs, especially when there are political issues involved.  It that were the case, I would dismiss it.  But the market correction could be giving people pause.  I am not sure that a potential Russian invasion of Ukraine has entered the public’s psyche, and it could take an actual invasion and a forceful U.S. reaction before the confidence measures see any impact.  The point is, the risk is to confidence is to the downside.

The big shocker of the day came from the Philadelphia Fed, whose NonManufacturing index plummeted into negative territory.  This is a diffusion index and is notorious for its volatility, but the drop was larger than any other time over its eleven-year existence except in March and April of 2020, when the pandemic and shutdowns hit.  That says something, though I am not sure exactly what.  That’s because the details were weak but for the most part, didn’t point to an actual slowdown in activity.  The new orders, sales and employment indices fell sharply, but remained positive.  Increases in prices received and paid were more widespread and wage costs continued to accelerate sharply.  Those are not indicators of a faltering economy.

On the housing front, another month of data, another round of sharp price increases.  Yes, the year-over-year gains for both the Case-Shiller and Federal Housing Finance Agency price indices are trending downward, but the pace remained extraordinarily high in November.  There are few indications that supply will increase enough in the near term to cause the price gains to decelerate sharply.    

IMPLICATIONS:  We are going to see if Chair Powell and the rest of the Fed’s Board of Governors and Regional Bank Presidents have backbones.  The Fed has bowed to the markets for so long that several years ago I started referring to the Fed’s mandate as a triple one, not a dual one.  Maintaining high and rising equity prices was the third component.  With inflation remaining well above acceptable levels, even in an average rate over time policy world where higher than target price gains are tolerated, you would expect the Fed to stay the course on its appointed rounds of rate hikes.  I expect that to be the case, but if the equity markets continue to falter, when we get to the March 15-26 meeting, I am not sure what the FOMC do.  I was expecting a 50-basis point show of force in March, but that could be off the table.  The markets may dictate what the Fed does once again, and if that happens, it is too bad.  As I have noted before, the Fed has done everything but bash investors over the head with a sledgehammer to warn them that rate hikes are coming.  That suddenly, everyone is worried about rate hikes proves another of my favorite sayings: “Markets may be efficient, but that doesn’t mean they are rational”.  Although, failing to heed Fed warnings also brings into question the efficiency of markets.  Basic information just doesn’t seem to spread easily.  Instead, the friction of mob, or maybe lemming mentality appears to be keeping bad news from being distributed.  Regardless, we have to see how much further the markets fall and how quickly they recover to get a handle on the impact on consumer confidence and Fed policy.  Recent market corrections were reversed fairly quickly.  Hopefully, that will be the case this time as well. 

Real Earnings: +0.1%; Over-Year: -2.4%; Hourly Earnings: +0.6%; Over-Year: +4.7%; HWOL: +6.3%

IN A NUTSHELL: “Could the fastest increase in consumer prices in forty-years lead to the Fed raising rates by 50 basis points in March?”

WHAT IT MEANS: Businesses are worrying about rising input and wage costs, while households are distressed at the surging consumer prices, and they both have cause for concern.  Inflation jumped again in December, though the pace was down from what we saw in October and November. Since December 2020, prices were up 7%, an increase not seen since the wage/price inflation spiral days in the early 1980s.  Excluding food and energy, the rise over-the-year was the greatest in thirty years.  In other words, the “bad old days” are back.  Not really, conditions are different, but inflation is showing few signs of decelerating.  In December, there were strong increases in just about every major component except energy goods and services.  Commodity costs, excluding food and energy, have risen nearly three times as fast as services, as medical and shelter costs were up more moderately than most other components.  Used vehicle prices continue to skyrocket as new vehicle supplies remain tight. 

Wages may be surging, but consumer prices are going up just as fast, if not faster.  Hourly earnings jumped in December, but when adjusted for inflation, they were up minimally.  Worse, over-the-year, real wages declined sharply.  Households are seeing their purchasing power disappear and that is not good news for the economy. 

The Conference Board’s Help Wanted OnLine index rebounded sharply in December, after having cratered in November.  This measure doesn’t usually bounce around this wildly, but the trend is up and the level of want ads is at a record high.  To the extent that firms can find available workers, it looks like they will be hiring just about every one of them.      

FED POLICY IMPLICATIONS: Prices are rising at levels not seen since former Fed Chair Paul Volcker decided it was time to use the nuclear option – massive interest rate increases that would crush the economy and squeeze inflation pressures out of the system.  The time to face the inflation threat, even if it is currently not close to what it was forty years ago, has arrived.  Fed Chair, Jay Powell is not likely to go the Volcker route, but he made it clear that the days of feeding the economic and market beasts with massive liquidity are coming to an end.  Today’s report backs for the Fed’s view that it not only has to stop adding support to the system, but it needs to begin withdrawing it, both in terms of raising rates and reducing its balance sheet. Don’t be surprised to see the asset purchases end by March and the rate hike process begun at the March 15-16 FOMC meeting.  How fast will interest rates be increased and liquidity be withdrawn from the economy?  The consensus is for the Fed to raise rates at its usual pace, 25 basis points every other FOMC meeting, or one percentage point a year.  However, that may not be the strategy.  We get two more inflation reports before the March meeting and if they continue to show inflation accelerating, I do not rule out a 50-basis point increase.  That would have to be signaled beforehand, but it would show that the Fed means business.  Its biggest concern is that higher inflation will become embedded in expectations, which would require even stronger action (no, not the nuclear approach). Mr. Powell commented at his reappointment hearing that he still felt that the supply chain-related issues would fade, though he has pushed that timing out toward later in the year.  A sooner-than-expected deceleration in inflation would provide the Fed some breathing room, but that doesn’t seem to be the likely case.  Regardless, the funds rate is going up and barring an economic collapse, look for it to rise at least two percentage points over the next two years.   

KEY DATA:  ISM (NonManufacturing): -7.1 points; Orders: -8.2 points; -1.6 points/ Trade Deficit: $13 billion wider (19.4%); Exports: +0.2%; Imports: +4.6%/ Claims: +7,000

IN A NUTSHELL: “Growth is moderating, though it still looks as if the fourth quarter increase will be quite strong.”

WHAT IT MEANS:  The Fed is signaling that rate hikes are coming and there is good reason for that to be the case: The economy continues to grow solidly, even if the pace is moderating.  The Institute for Supply Management’s non-manufacturing index dropped sharply in December.  That followed a less dramatic decline in its manufacturing measure.  Yet neither dip points to major economic issues.  Why?  The level of activity remains quite high.  It’s just that we are coming off of huge increases that were not sustainable, especially with government stimulus funds slowing or running out. New orders remain solid, though not booming.  More workers are being hired and while backlogs are building less rapidly, they are still growing.  Essentially, growth is trending back toward a more sustainable pace, which is what was expected.  The major disappointing component in the report was costs of goods.  Prices paid for supplies and services grew at an even faster pace.  That is different than we saw in the manufacturing report, where input expense gains eased sharply.

The trade deficit, as expected, widened significantly in November, as exports increased minimally, but imports surged.  It would have been worse, but there was a huge increase in service exports due to the borders being opened to foreign travelers.  The goods deficit skyrocketed.  Price increases also hyped the size of the changes. On the export side, only the sale of food products rose over the month.  The remaining categories posted good-sized declines.  As for imports, we bought more of everything from the rest of the world.  The trade deficit for the first two months ran at the same pace as the third quarter.  But with some progress being made at the ports, I expect the widening of the deficit to continue in December, so for the quarter, trade will likely restrain growth.

Jobless claims rose last week, but the level is ridiculously low, especially when you adjust for the size of the labor force.  Firms are just not cutting workers loose out of fear they will be unable to replace them.  Indeed, Challenger, Gray and Christmas reported that layoff announcements in 2021 were the lowest since they started collecting data in 1993.

IMPLICATIONS:The equity markets never stop amazing me.  Yesterday, the Fed released the minutes from its December meeting and not surprisingly, it was indicated that the members were growing quite worried about inflation and that a rate hike could come as soon as the March meeting.  The markets tanked on that news.  Duh, has anyone been listening?  Central banker after central banker has been speaking about how inflation was now a concern and that rates would be going up.  The Fed’s forecast, released after the December meeting, pointed to as many as three increases.  Yet when the Fed put into print that it would be doing what it has been signaling it would be doing, investors suddenly got worried.  Does the Fed have to hit people over the head with a sledgehammer to get them to listen?  Barring a major shock, rates are going to be hiked at the March, May, or at worst June meeting.  Does a couple of months really matter?  No.  But I guess for the Rip Van Winkles it does.  The point is, even with the economy decelerating, inflation is not going to come down rapidly.  Growth is strong enough to support rates hikes.  Unfortunately, the Fed has trained households and businesses to believe that the once-called “emergency” low rates are normal rates.  When you keep rates near the bottom for a decade, that’s what should be expected.  Thus, any talk of rate increases worries people, even though it will take quite a few increases (and probably several years) before the level even approaches long-term normal.  The Fed needs to clean up the mess it created by keeping rates so low for so long and it is good that it will be starting to do that – the sooner the better.   

KEY DATA:  ISM (Manufacturing): -2.4 points; Orders: -1.1 points; Prices: -14.2 points/ Openings: -529,000; Quits: +370,000

IN A NUTSHELL: “Growth may be moderating, but workers still see this as a great time to find other jobs or even other things to do.”

WHAT IT MEANS:  Yes, the economy is no longer growing at an unsustainable pace, which is good news.  So, don’t worry too much about the moderate decline in December manufacturing activity reported by the Institute for Supply Management.  Indeed, there was some good news in the details.  First, the level of overall growth is still strong, and orders continue to expand at a very solid pace.  As a result, hiring accelerated and order books fattened.  Those point to continued improvement in the economy during the early part of this year.  But the eye-opening number was the prices paid component, which dropped sharply.  We could be starting to see some moderation in the rise in production costs. The index is not pointing to low inflation, just lower inflation. 

Job openings dropped sharply in November, though it is hard to argue that the labor market is faltering.  The level is not that much below the record high reached in July, and nearly matched in October.  To put things in perspective, the pre-pandemic high, which was set in November 2018, was 7.5 million.  The November level was nearly 10.6 million – almost forty percent above the pre-pandemic peak.  There are a ton of jobs openings, and workers are taking advantage of it.  The number of people quitting reached a new high and is about twenty-five percent above the pre-pandemic peak.  It is likely the number of workers quitting will rise a lot further during the first half of this year.     

IMPLICATIONS:  Delta took its toll on the economy in the late summer/fall, and it is looking as if Omicron is doing the same now.  But that doesn’t mean the economy is falling apart, it is not.  All that is happening is growth is decelerating from the unsustainable rate we saw when economy was reopening and the government was shoveling money out to businesses and households at an incredible pace.  Remember, when something is unsustainable it usually means there are excesses being created that lead to issues in the future. And we have seen that, especially when it comes to inflation.  So, more reasonable growth is good.  The first positive sign of that is the moderation in manufacturing cost increases.  Expenses are still rising rapidly, so don’t look for a major easing in inflation, but at least the increase is decelerating.  As for the labor market, employers are not getting any relief.  The level of unfilled positions is extraordinarily high, and workers are getting very comfortable with changing jobs or just plain quitting.  Hiring is robust and layoffs are extremely low, so the excess demand is not going away.  Friday, we get the December employment report, and it should be solid.  What I will be watching is the wage component.  The supply managers may be seeing a moderation in raw material costs, but if wage gains are still accelerating, inflation is not likely to slow significantly anytime soon.  If the November Paychex Small Business Wage Index is at all on target, hourly wage gains should be strong again. 

Commentary: FOMC Decision

Yesterday, the Federal Reserve’s rate setting group, the Federal Open Market Committee, decided that it was time to face reality.  Having been lampooned mercilessly for its consistent message that the high and rising rate of inflation was “transitory”, it decided to abandon the “don’t worry, be happy” message and changed course dramatically.  Rate hikes are coming sooner and faster than expected, but they are needed and therefore welcomed.

Here are some of the key takeaways from the Fed’s statement, forecast and fed funds dot plot.

No more transitory: First, and most importantly, the term “transitory” was dropped.  That was hardly a surprise, but it did set the stage for everything that came afterward.  Instead, the Fed simply noted that “Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation.”  In other words, there was no attempt to forecast the length of time the economy could face elevated inflation, except to say that it will not come down until the pandemic eases and the supply chain problems dissipate. 

Forget “tapering”; it’s now “vanishing”:  The open-ended outlook for elevated inflation provides the Fed with the foundation needed to accelerate the ending of its asset purchase program.  The “tapering” was accelerated and will now finish by March.  That is important as it does two things: First, it sets the stage for an earlier increase in rates.  You have to stop easing before you can start tightening.  Second, it makes it clear that there is an urgency to the process.  That is, inflation really is a concern.

Full employment is the trigger for rate hikes: Once the tapering is done, the Fed signaled it will start raising rates soon afterward.  It set a target for when that would happen when it noted that “the Committee expects it will be appropriate to maintain this target range (0%-0.25%) until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment.”

With the unemployment rate currently at 4.2%, the FOMC may not have to wait long for the target of full employment to be met.  Looking at the forecast, the Fed’s median longer-run forecast for unemployment (i.e., full employment) is 4.0%.  That could be met sometime in the spring – and maybe sooner. 

The tapering ends by March and full employment could be hit not long afterward.  Consequently, the March 15-16, 2022 FOMC meeting looks like the earliest date the Fed might start tightening, with the May 3-4 meeting being the likely one, at least right now.

“Don’t go slow, just get it done”: Maybe the most startling part of the message sent was that the Fed may not raise rates as slowly as expected.  The Economic Projections Table indicated that as many as three rates hike could occur in 2022.  That is really nothing excessive.  Indeed, the forecast now suggests there would be another 100 basis points in both 2023 and 2024.  Three years to get back to long-term rate levels is hardly breakneck speed.

Summary:  The economy is growing solidly, job and wage gains are strong, the unemployment rate is nearing full employment, but inflation is high and showing minimal signs of decelerating rapidly.  This environment calls not just for the ending of monetary stimulus, but a tightening of policy so it gets back to something closer to neutral.  That is what the Fed said yesterday, and it should be good news for the markets and the longer-run health of the economy. 

(Next FOMC meeting: January 25-26, 2022)