The premise behind my bullish outlook for the market and the economy for the past several months has been that the rate of inflation would fall much faster than consensus expected. That would allow the Fed ending its rate hike campaign before the end of the year, resulting in a top rate significantly lower than the 5-5.25% range the markets represent. It would also allow consumers to achieve real wage growth this spring, helping support spending, and weaken the dollar, giving S&P 500 corporate earnings a much-needed tailwind. This would pave the way for a soft landing in 2023. We took a big step in that direction with yesterday’s CPI well below expectations with the exception of mine resulting in the best day ever for the major market averages in more than two years. .
the header number for the Consumer Price Index fell for the fourth consecutive month on an annualized basis from 8.2% in September to 7.7% in October. The underlying rate, without food or energy, went from 6.6% to 6.3%. Both were way below expectations. The monthly increase for the core of 0.3% was the smallest in more than a year. Prices for used cars and trucks, airfares and clothing fell. The biggest decline was in health care services, but that was largely due to an annual adjustment in how the government tracks health care prices and it won’t be repeated. The most encouraging aspect of the report is that the increase in housing costs accounted for more than half of the monthly increase in the main number and more than 40% of the core.
In fact, the housing component experienced the largest monthly increase since August 1990 with 0.8%. The reason I find this so encouraging is that I think housing costs have a greater chance of going down in the next 6 to 12 months than any other component of the index.
The reason is that price increases for new leases have slowed significantly, while some are experiencing price declines in select locations. These new contracts will take time to reduce the current average rent, but everything indicates that this is happening.
Another extremely positive development in this report, which was ignored, has to do with real wages. Despite the tremendous nominal wage growth we’ve seen over the past year, especially for low-income workers, inflation has eroded all of those gains and then some. resulting in a loss of purchasing power. However, if you look at average (real) inflation-adjusted hourly earnings growth in the chart below, you’ll see that the erosion is slowing. The 2.8% year-over-year decline has fallen to 2% over the last six months annualized and is now flat over the last three months annualized. As the rate of inflation continues to fall, we are back at the cusp of real wage growth. This should help support consumer spending in 2023.
A lower rate of inflation suggests that we will see lower interest rates, which is why we saw a sharp drop in the dollar index yesterday. That fueled the stock market rally. Multinational corporations highlighted the strength of the dollar as a major headwind to revenue and profit growth last quarter. Its reversal will serve as a tailwind for both in the coming quarters.
The bears will argue that yesterday’s tremendous one-day rally in stocks was typical of bear market rallies. They will claim that the Fed will continue to raise the fed funds rate to 5-6% next year, resulting in a demand-driven recession. I couldn’t disagree more, but the Fed’s rhetoric between now and the end of the year is bound to support this ominous outlook, because the Fed wants to keep inflation expectations in check as it works to bring the real rate down to its target. My recommendation is to watch what the Fed does instead of listening to what its members say they can do. Fed actions should continue to depend on the data, with data to date suggesting that it will raise rates after the December meeting with another 50 basis point hike and a 4.25-4.50% rate target. If I’m not mistaken, then the consensus is outperforming its 2023 top rate expectation by 75-100 basis points, and reining in that expectation is new fuel for riskier asset prices.