Price Stability in Focus for the Fed

We expected 2022 to be a bit of a rocky ride, and we’ve seen that in vivid detail to start the year. It’s a puzzling market environment when accounting for inflation, interest rates, equity valuations and fixed income options. When the proverbial stew is churning, it’s tempting to reach for performance or abandon an asset class altogether to pile into another. But reducing portfolio diversification is risky, as it runs counter to a durable, time-proven approach to growing and maintaining wealth. An analysis by Northwestern Mutual’s investment team shows just how durable the balanced approach can be. 

On the recent selling in stock markets: It’s been a purging of speculative, expensive parts of the market that were aided by incredibly accommodative monetary and fiscal policy. The downturn started in “hopes, dreams, themes and memes” stocks and spread to longer-duration growth stocks (valuations reflect many years of growth). Initially we saw a rotation from speculative to more value sectors of the market, but we’re now seeing broader market selling on increased fears. We think this will pass and fundamentals will again carry markets as the year advances.

Wall Street wrap

Fed Holds Steady, but a Notable Shift in Focus: “The economy no longer needs sustained high levels of monetary support,” Federal Reserve Chairman Jerome Powell said last week following the central bank’s first policy meeting of 2022.

Asset purchases will come to an end in early March. We knew that. Powell also said it “will soon be appropriate to raise … the federal funds rate.” There are no mysteries here, though some may argue what “soon” means in Fedspeak or about the pace at which it will raise rates.

There was a subtle shift from Powell that’s worth noting. He spent significant time discussing price stability during the briefing. That’s in contrast to the prior two years, in which full employment was squarely in focus and prices were more of an afterthought. It’s a rhetorical shift driven by inflationary trends that are proving less transitory than expected. 

“Price increases have now spread to a broader range of goods and services; wages have also risen briskly, and we are attentive to the risk that persistent, real wage growth in excess of productivity could put upward pressure on inflation,” Powell said. Case in point: Employers spent 4 percent more in Q4 of 2022 vs. 2021, an increase not seen since 2001.

To achieve and maintain full employment, Powell explained, it’s critical to lengthen the economic expansion, but stable prices are necessary to sustain an expansion. Price stability, therefore, is a prerequisite in fulfilling the Fed’s employment mandate. The Fed is prepared to use policy tools to achieve that end, but it isn’t proceeding aggressively or in a way that would hasten a close to the economic cycle. The Fed still believes this recent surge in inflation is tied to COVID-19 and will alleviate in 2022 as heightened, “shifted” demand cools, supply chains heal and inventories are restocked. The Fed is proactively addressing risks and rhetoric around prices before inflation entrenches in consumer behavior and potentially endures.

Key Inflation Metrics Remain Elevated: The gauge used by the Fed to measure inflation, core PCE, rose 4.9 percent from the prior year, keeping the pace of price gains near multi-decade highs. The core expenditure index strips out more volatile categories like food and energy. Month over month, core PCE rose 0.5 percent, in line with expectations. PCE inflation, which includes all categories, rose 5.8 percent year over year. Goods inflation continues to move the headline number, with prices rising 8.8 percent year over year. In 2021, consumer spending shifted to goods over services, diverging from an established, multi-decade decade trend of households allocating a growing share of budget to services. This shift in preferences put immense pressure on supply chains that were exacerbated by labor shortages and omicron. Inflation spiked in product categories that had operated in an environment of flat to declining prices. The shift to goods is a big reason inflation is elevated.

However, data show consumers are reverting to their old ways: favoring services over goods. That’s allowing supply chains to catch up, and GDP data (below) show significant spending on inventory builds in the quarter. Goods spending is also returning to trend, while services spending continues to grow modestly. This combination will take some wind out of inflation’s sails.

GDP Growth Sprints to Finish in Q4: The U.S. economy grew at a real 6.9 percent annual rate in Q4, pushing the 2021 real annual growth rate to 5.7 percent (after 2020’s -3.4 percent), the fastest rate since 1984 during President Ronald Reagan’s first term. Importantly, the data showed that inventories are being rebuilt and replenished. The U.S. Commerce Department said 4.9 percent of the increase in GDP came primarily via private-sector inventory investments (businesses looking to get product on the shelves), especially among retailer and wholesalers. That’s a good sign, as shortages were a big contributor to rising inflation, and the data indicate those shortages are getting fixed.

The GDP data also showed for the second straight quarter that consumers shifted their spending preferences back toward services (away from goods).  During COVID, consumers have pulled forward goods purchases, which are an inflation-adjusted 15.4 percent above year-end 2019 levels; while services spending is roughly flat (-0.35 percent). Omicron’s rise in January could pause this trend, but we believe it will continue in 2022, thus alleviating the current inflationary pressure on goods.

Consumer Outlooks Remain Mixed: The Conference Board’s Consumer Confidence Index pulled back slightly in January, falling to 113.8 from 115.2 the month prior. It’s a slight moderation in the outlook, following three months of improvement. Consumers’ assessment of the current business and labor market improved. Still, more people say they’re in the market for a car or appliance. Concerns about inflation, though still elevated, also declined for the second consecutive month.

The week ahead

• Monday: Q4 GDP growth in the eurozone is due this morning. We think conditions are in place for the eurozone to stage a U.S.-like, robust recovery — it’s just lagged the U.S. for now. While growth in the eurozone is expected to be more modest than in the U.S., we’ll keep tabs overseas. Tensions in Ukraine, high energy prices and omicron are key uncertainties.
• Tuesday: The ISM manufacturing index for January will be released in the morning. As always, we’ll be looking for continued growth while monitoring labor, prices and supplier updates. Earnings are on tap from Alphabet (Google), Exxon Mobil, Starbucks, General Motors, PayPal and UPS.
• Wednesday: Abbvie, Thermo Fisher Scientific, Humana, Qualcomm, Spotify and Waste Management are among companies reporting earnings.
• Thursday: The European Central Bank will hold its January policy briefing, though it isn’t expected to alter interest rates or its asset purchase program. The ISM services index will also be released in the morning and is expected to remain firmly in growth territory. Earnings are due from Amazon, Eli Lilly, Cummins, Ford, Merck, Hershey, Estee Lauder Companies, Honeywell and Snap Inc.
• Friday: The January 2022 employment report will close the week, and we’ll see the full impact of omicron disruptions reflected in the results. COVID-19 cases averaged 803,000 in January, compared with 127,000 in December, according to Moody’s.

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