The Economy Is Ready to Walk Without the Fed’s Help

As we head into the final weeks of 2021, the markets are grappling with a pair of uncertainties. First, it’s clear the Federal Reserve will strike a new monetary policy tone in 2022. The Fed is accelerating away from emergency policies established to support the economy during peak pandemic-driven uncertainty and toward a more “normal” policy backdrop (more on that below). Of course, that’s opened a can of worms for markets. With inflation at a 39-year high, is the Fed moving too slowly? Will it have to course correct abruptly? Is the economy ready for rate hikes next year? Overall, markets are wondering if the Fed is going to make a policy mistake next year.

The omicron variant is also capturing more attention as it rapidly gains a foothold in the United States and abroad. Heading into the holiday gatherings, case counts are rising once again, and local hospital capacity is strained in some parts of the U.S. Both here and abroad, contagion prevention measures such as mask mandates and business restrictions are back, but at a diminished scale compared to 2020.

Markets, as tends to happen, are amped on fears that these twin forces have potential to hamstring growth. We aren’t so sure. In terms of the Fed, we believe the economy is on strong footing and can stand on its own without as much support from the Fed. Regardless, even when tapering is complete and a few rate hikes go into effect, it’ll remain an accommodative policy backdrop. We just don’t think the Fed will have a dramatic impact on real economic growth, though some overheated pockets of the market may come back to earth as rising interest rates alter long-term, highly ambitious growth projections.

To omicron: Outbreaks and the measures to slow them could cause some minor disruptions to growth, but nothing near the scale we saw in 2020. The experts (thus far) believe this variant spreads far more rapidly, but infections lead to less severe disease. Vaccines, along with a booster, are believed to be effective. And, as we have repeatedly said, society has adapted to life during a pandemic and life and business will carry on — with a few adaptations, of course, but in all, not enough to alter our outlook for solid economic growth through 2022.

Now, to the week that was and the week ahead.

Wall Street Wrap

Fed to Accelerate Pace of Tapering: The big news of the week was the Fed’s decision to accelerate its tapering program. Rather than paring purchases by $15 billion every month, it will reduce purchases by $30 billion each month, putting it on pace to end its purchases by March (it had been buying $120 billion in bonds monthly). The Fed’s “dot plot” also hinted at three rate hikes 2022, one more than originally forecast.

Markets largely received the news in stride, and stocks hit session highs as Powell took to the podium on Wednesday. That’s because it’s a sign that the economy is doing well. Indeed, unemployment is falling, and growth has proven resilient through 2021. And even after tightening in 2022, the “dot plot” indicates the Fed expects the interest rates to hover around 2.1 percent at the end of 2024, which is below their current neutral rate estimate of 2.5 percent. The neutral rate is an interest rate that is neither accommodative nor restrictive.

We also think the market liked Powell’s comments that the economic cycle will need to persist to improve labor force participation. The risk to extending the economic cycle is, of course, higher inflation. The takeaway for investors, it appears, is the Fed isn’t looking to kill the economic cycle by overtightening; rather, the central bank is attempting to fine-tune its policy in the near term to help extend the duration of this economic cycle.   

In the near term, the economy is strong enough to handle a monetary policy shift through 2022 — it doesn’t need massive, $120 billion infusions of liquidity to remain healthy. We also think inflation becomes less of a concern as some oddities in spending and the labor market normalize. As always, keep in mind these are simply Fed projections and are subject to change. As Powell has said in almost every 2021 presser, the Fed will remain observant and adapt as market and economic conditions dictate.

Retail Sales Slightly Decelerate: Sales at retailers, online stores and restaurants rose a seasonally adjusted 0.3 percent in November compared to a 1.8 percent month-over-month rise in October, according to the U.S. Commerce Department. While that’s certainly a downshift in pace, November’s tally was still 18.2 percent higher than 2020 levels. Consumers, concerned about inflation and shortages, may have frontloaded a lot of holiday shopping in October, leading to a deceleration in sales growth.

Of note, online sales were flat, while in-store sales increased from 2020 levels, according to data from Mastercard. Overall, while retail sales in November may not have exceeded expectations, consumers are still in great shape and willing to spend despite inflation and pandemic-driven concerns.

Wholesale Prices Surge: Wholesale prices were another factor accentuating inflation concerns last week. The producer price index, which measures the input costs businesses pay, rose 9.6 percent year over year in November. That’s the highest mark since the current data series began in November 2010. Naturally, that headline figure comes on the heels of a 39-year high CPI read earlier this month. Energy, food, transportation and warehousing were primary drivers.

While this is another elevated headline read, we think we’ll see spending and prices normalize through next year as the labor participation rate improves and consumer spending behaviors fall back closer to long-term trends.

And the Rest: A quick survey of some other data reaffirms our view that all is well when it comes to economic fundamentals. The NFIB small-business index improved from 98 to 98.4 in November. Supply chain issues and prices remain a concern, though optimism has slightly improved. Home builder confidence remains elevated, as both building permits and housing starts improved in November. Flash reads from the IHS Markit manufacturing and services indexes showed a slight pullback, though both indicate economic expansion.

Overall, there’s little that gives us concern in the data.

The Week Ahead

It’ll be a lighter week for data given the holiday. As a reminder, because Christmas falls on a Saturday this year, markets will be closed on Friday, Christmas Eve. For the week, the December consumer confidence report will drop on Wednesday. On Thursday, the busiest day, markets will parse durable goods orders, capital goods, personal income and spending, initial unemployment claims and the PCE deflators (a measure of inflation based on changes in personal consumption).

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