The Fed Shows Signs of Weighing the Risk of Overtightening

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

Stocks edged higher in a volatile week as investors grew increasingly optimistic that the Fed was either at or nearing the end of its rate hiking cycle. The view was fueled by Fed Chair Powell’s comments after announcing the latest 25-basis-point rate hike last Wednesday. While the hike was widely expected, Powell’s disclosure that the board of governors had considered leaving rates unchanged at the latest meeting underscores how quickly economic narratives can change in an evolving business climate. Recall that it was less than a month ago that Powell had suggested a 50-basis-point hike may be necessary at the March meeting due to the still strong job market and some signs of an uptick in the economy.

The abrupt acknowledgement that rate hikes were having an impact on financial conditions and acting as a drag on the economy was sparked by the failure of three U.S. regional banks and the forced sale of a troubled Swiss bank. However, the contributing conditions leading up to the closures — a decrease in long-term bond values due to rising rates and a lack of liquidity for speculative industries — were already well known. Similarly, in our view, data over the last several months has been signaling the economy was heading toward or on the cusp of recession. Yet the broader picture has been largely overlooked until now as the Fed and investors focused on individual data points and ignored the totality of the information.

Consider that for much of the past year, reports that inflation was beginning to recede and the economy was cooling were often met with “yes, but ...” from inflation hawks. For example, shipping costs were a focal point in the third quarter of 2021, when overseas container costs peaked at $10,377. However, as they started to ease, eventually returning to their pre-spike level of $1,700, inflation hawks countered with “Yes, but look at commodity prices,” which were spiking in response to Russia invading Ukraine. Similarly, when goods inflation began to ease in the middle of 2022, Powell pivoted to highlighting rising services and shelter costs. And when lagging shelter costs began to ebb, the Federal Reserve started to focus on so-called “super core” readings that strip out the effects of shelter and energy.

We highlight the ever-shifting focus on individual factors not to relitigate past disagreements we’ve had with the Fed but as a reminder of the importance of relying on the preponderance of data when forming a robust economic view.

Based on our read of the data, we continue to believe that disinflation (i.e., the falling rate of inflation) continues to gain momentum and that despite a few recent reports showing modest improvements in activity, the economy as a whole remains sluggish; and we believe that a mild, shallow recession remains a likelihood in 2023. And given the already considerable progress made on the inflation front, as well as still tempered inflation expectations and slowing wage growth, the Fed will have room to cut rates should the economy contract more rapidly than is currently expected.

Wall Street Wrap

Mixed data on the economy: Preliminary readings from the S&P Global Composite Purchasing Managers Index showed an uptick for the economy with the Composite output Index reading of 53.3, up from February’s reading of 50.1 and the highest level since April 2022. However, the latest numbers show that despite overall activity moving higher, manufacturing remained mired in recession territory, with a reading of 49.3 (readings below 50 indicate contraction). The level was an improvement from February’s 47.3 but marked the fifth consecutive month in recession territory. Input costs continued to improve, with the latest data marking the slowest increase in costs since July 2020. In an effort to maintain sales, manufacturers passed those savings on to customers, and prices charged grew at the slowest pace since October 2020. The services side of the economy perked up, with a reading of 53.8 — indicating a second consecutive month of modest expansion. However, prior to February’s reading, the services side of the economy registered seven consecutive months of contraction.

The Chicago Federal Reserve’s National Activity report — a measure of 85 monthly economic indicators to measure U.S. economic activity — showed contraction with a reading of -.19 for February. Readings above zero indicate above trend growth, while readings below zero are interpreted as a sign of contraction. The latest number marks the third of the past four in negative territory. While the latest figure is not at recessionary levels, the recent volatility of the measure highlights the up-and-down nature of the economy. It’s a sign of the “lumpiness” that can occur when measuring the economy in real time and underscores the importance of monitoring trends.

Housing market perks up: The National Association of Realtors reported that existing home sales in the U.S. jumped 14.5 percent in February to a seasonally adjusted annual rate of 4.58 million units. The latest figure represents the first increase in home sales in 13 months. On a year-over-year basis, sales were down 22.6 percent. The inventory of unsold homes was unchanged. It’s worth noting that the median sales price for February was 0.2 percent lower than they were one year ago, the first decline since February 2012. As mortgage rates have fallen in recent months, affordability has improved modestly and has likely benefited price-sensitive buyers the most.

New home sales also picked up in February, according to the latest data from the U.S. Census Bureau. The report shows the seasonally adjusted annual rate climbing to 640,000 units per year, an increase of 1.1 percent from January’s revised reading. However, on a year-over-year basis, new home sales were down 19 percent.

The week ahead

Tuesday: The S&P CoreLogic Case-Shiller index of property values will be out before the opening bell. Home sales and prices have continued to sag despite easing mortgage rates in recent weeks. We will be watching to see if the cooling of the housing market has begun to slow.

The Conference Board’s Consumer Confidence report will come out in the morning. We expect recent headlines about the banking sector will weigh on confidence. We will be on the lookout for any changes in trends as well as the labor market differential, which is based on the difference between the number of respondents who believe jobs are easy to find and those who report challenges finding work.

Thursday: Initial and continuing jobless claims will be announced before the market opens. Initial filings dropped last week, and we will be watching for signs that the employment picture is weakening.

Friday: The February Personal Consumption Expenditures price index from the U.S. Commerce Department will be out before the opening bell. This is the preferred measure of inflation used by the Federal Reserve when making rate hike decisions. We will be scrutinizing this report with a particular focus on the services side of the reading.

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