Heroes Of The Last War

Effectively, last week was the final week of 2022 from the market’s perspective. The US CPI report and the December FOMC meeting were the last of this year’s event risks, and considering how arduous 2022 was, most will be glad to close the books and flip the calendar.

But the data docket isn’t blank in the US ahead of Christmas. Mercifully for holiday loners like myself, opportunities to editorialize abound.

The headliner is November personal income and spending accompanied, of course, by the PCE price gauges. Barring a total surprise, the market impact will be blunted by the benign read on CPI last week and the proximity of the release to the holiday (the PCE figures are due Friday).

Consensus expects a 0.2% MoM gain on the core PCE gauge (figure below). An in line print would “confirm” the signal from CPI and thereby support various peak inflation narratives.

Needless to say, any sort of upside surprise would be unwelcome, but given the Fed’s (re)stated intention to hold terminal for the entirety of 2023, and the market’s tendency to treat the PCE gauges almost as an afterthought depending on the evolution of the CPI prints that precede the personal income and spending report each month, it’d take a wholly inexplicable beat to shock markets into caring on the eve of… well, on the eve of Christmas Eve.

That said, do note that quite a bit of the fundamental consternation last week was down to the Fed’s upwardly revised core PCE projection for 2023 (figure below). The new median was 3.5%, up markedly from the September projection and, some suggested, inconsistent with observed progress from recent price data.

That upward revision (denoted by the red arrow) went a ways towards explaining the higher terminal rate tipped by the new dots.

To be sure, 3.5% would represent a marked improvement from current levels, but it nevertheless irked traders hoping to see “peak inflation” reflected in real-time by the SEP in the form of a terminal rate short of 5% and a mere nod to persistent upward pressure on core prices as opposed to a material upward revision.

The issue is core services and the link to wages. The figure (below) shows private sector wage growth from the ECI report, which the Fed watches like a — err — like hawk, if you’ll pardon the terrible joke.

This is one case where a “naive” overlay chart works just fine. The relationship between wage growth across the economy and core services inflation is clear. Much like all inflation-related dynamics, this is a bit of a chicken-egg dilemma, and the Fed needs to solve it. Chicken-egg dilemmas aren’t easy to solve.

“The persistently elevated rates of core services inflation linked to a tight labor market [are] the main concern for the Fed for 2023,” TD analysts including Jan Groen and Oscar Munoz said. “Despite the downside inflation surprise in the November CPI report, the report did not contain anything that takes away from this concern,” they added. “Wages have been catching up with higher expected inflation throughout this year and remain at levels consistent with 4% inflation rather than 2%, thus locking at least partially elevated inflation rates into 2023.”

That, in essence, is behind the Fed’s stubborn view, which the market plainly believes is out of date. The disagreement continues to manifest most clearly in market pricing for rate cuts in the back half of 2023 (updated figure below).

At this point, the market doubts both pillars of the Fed’s plan to fight inflation next year: Traders don’t see the Fed getting into the “fives” (as Powell put it, during last week’s press conference) and they don’t think the Fed will hold terminal for longer than a meeting or two.

“Despite a skew of 2023 dots that implies upside risk to the median 5-5.25% projection, and Chair Powell’s insistence that the Fed will hold the policy rate at high levels for some time, markets have chosen to ignore this messaging,” Goldman’s Praveen Korapaty wrote late Friday. “Not only is the market’s peak rate below Fed projections, but it appears investors are either expecting easing because of a fairly rapid return to ‘normal’ levels of inflation or placing fairly high odds of a recession shortly after the peak.” I’d suggest it’s both, but more the latter than the former.

The irony, of course, is that the harder Fed officials push the envelope, the less likely the market is to buy their narrative.

Rightly or wrongly (it’s rightly) the Fed has garnered a reputation for fighting the last war. They fought deflation when CPI was accelerating rapidly, and now traders are convinced they’re poised to fight 2021’s inflation battle in 2023, leading invariably to recession. Hence markets’ growing conviction in rate cuts commencing as soon as July.