Fed Policy is Working

Wholesale inflation slowed more than expected in December, and November’s gain was revised lower. The Producer Price Index (PPI) decelerated sharply from a year-over-year rate of 7.3% to 6.2%. Underlying inflation—excluding the more volatile categories of food & energy—slowed to a 4.6% rate. I mention this because it is now abundantly clear to investors—if not the public, politicians or the media—that inflation has been beaten. The Fed’s 2022 rate hikes have already constricted financial conditions sufficiently to put us on the right path. I suppose we’re just waiting for confirmation as backward-looking economic data flow in.

But capital markets aren’t waiting. Investors are already looking forward. That’s why the S&P 500 stopped falling in October. It’s also why bond yields stopped rising in November. Inflation is now normalizing faster than expected, and that means the Fed has a chance to engineer a “soft landing.”

As I said, the Fed’s policy is aimed at normalizing the economy. That means slowing demand in order to slow inflation. We are beginning to see the impact on demand. Consumers pulled back on spending during the holiday season. US retail sales fell 1% in November and then another 1.1% in December. It makes sense, given high inflation, rising credit card interest rates, and fear of a recession. Retailers tell us consumers are looking for discounts and are more discriminating. And yet, I don’t want to make too much of it. On a year-over-year basis retail sales are up 6%, roughly equal to the rate of inflation. And with unemployment down around generational lows I don’t expect consumer spending to crash. Besides, investors are well aware that spending has shifted dramatically away from goods to services, which aren’t included in this report.

Normalization means undoing some of the excesses that characterized the Covid era. Today, Amazon (AMZN) announced it will lay off 18,000 employees, and Microsoft (MSFT) will shed 10,000. Why? They overbuilt, apparently assuming that the Covid-generated spike in demand would continue indefinitely. Amazon doubled its employees in two years, and boosted capital spending the 260%. Microsoft grew its workforce by 50% since the beginning of 2020. So it should come as no surprise that they need to shed some weight.