Yesterday, following CPI data that was worse than expected, the major indices all had a bad day, with the Dow dropping nearly 1300 points. However, as I write this, futures were suggesting an attempt at a rally this morning after the more forward-looking PPI came it right at the expected number, indicating that the worst of inflation may be behind us. Indeed, the markets have opened in the green as of press time, so does that mean that we have seen the lows in stocks?
It is important to remember that what the market is reacting to here is not inflation itself, but rather the Fed’s reaction to it. PPI and CPI data are currently being interpreted by traders in terms of what pressure they may put on the Fed to hike rates faster and further. Or could it be that the numbers hold out hope of a pause in the rate-hiking cycle, or even, as some optimists think is possible, a policy reversal and a small cut?
There are two basic problems with that optimistic view.
First, while a lot of the people trading and investing now have no real-world experience of inflation, those of us who remember the 70s and 80s can tell you that commodity price-driven jumps in consumer prices are just the start. When they come, they lead to higher wage demands, with workers understandably looking to at least stand still in terms of their buying power. More disposable income increases demand, pushing prices up further, and the vicious cycle begins. The relatively low power of organized labor in America, as opposed to in Europe, has muted the impact of that here to some extent. In the past, employers have said no to higher wage demands, and if workers didn’t like it, they were simply replaced.
That, however, can’t happen this time around due to a unique thing about this bout of inflation: it started at a time when the labor market was extremely tight. Industries of all kinds, but particularly those at the low end of the pay scale such as food service and hospitality, were struggling to find workers even before prices started to soar. That isn’t going to get any better when minimum wage doesn’t even cover rent costs across the country, so there is a small and shrinking pool of workers for whom a job at any wage is the priority.
We have yet to feel the inflationary pressure of wage demands, but with it starting to be seen from areas where labor is organized, such as rail workers, it is coming. That pressure will be exaggerated by the tight labor market and will offset small falls in PPI for a while. As a result, even as PPI suggests that we are past peak inflation, the measures of core inflation to which the Fed pays attention will likely stay elevated for several months.
That brings us to the second reason not to get too caught up in the optimism.
The Fed looks at those core numbers, not one month at a time, but on a rolling average basis. They are all too aware that one swallow doth not a summer make, and don’t want to give the appearance of being fickle and of flip-flopping between hawkish and dovish stances. Even if this morning’s PPI numbers do provide some hope, they won’t translate to lower core inflation for a month or two. And even then, the Fed won’t change course for another three months. That is a lot of time for more rate hikes. It also makes it likely that Jay Powell and the other Fed heads will be late to react to changing conditions, just as they were late to start tightening as they based that decision on old data.
In starker terms, they won’t change course until the economy has been showing signs of damage for several months. The market has to reflect that at some point.
After such a big drop yesterday, an initial bounce of sorts in stocks this morning was almost inevitable, almost no matter what the print on PPI turned out to be. The fact that it was as expected and showed a slight easing of input price pressure makes it possible that the bounce will be maintained throughout the trading day today but at some point, and maybe as soon as later today, the reality of rate hikes for several more months will set in. The market is trying valiantly to be optimistic, but it is false optimism right now, and a retest of the June lows looks far more likely than any real upward move in the coming months.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.