January CPI Report and its Implications

Stocks are volatile in early trading in the wake of a key inflation report (see below). At the moment, the Dow is down 260 points and the S&P 500 is down .5%. The VIX Index sagged below 20, suggesting little actual fear among traders.

In recent days the US dollar rebounded and bonds sold off. The primary reason seems to stem from investors’ realization that the Fed intends to keep interest rates a bit higher for a bit longer than previously thought. Of course, the Fed has been clearly stating as much. What’s changed, however, is the belief that the economy can take it. With the odds of recession falling, you’re not seeing huge bets placed on safe-haven assets like Treasuries and gold.

Inflation picked up last month due to higher gasoline prices and housing costs. The Consumer Price Index (CPI) rose .5% in January, which is the highest month-over-month rate in three months. And yet, according to Bloomberg News, economists and investors clearly saw this coming. And CNBC says the report was “largely better than feared.” On a year-over-year basis CPI continued to slow. The annual rate edged down to 6.4% from 6.5%. Core CPI—excluding food & energy—decelerated to 5.6% from 5.7% in the prior month. Small wonder the stock market recovered after the report was released.

But if there is disappointment, it is that the Fed will likely view the report as a green light to continue raising interest rates. We know that the labor market remains very tight and the economy in general is resilient. If these conditions persist, some worry that we won’t be able to knock inflation down to the Fed’s 2% target. This is one reason we believe the Fed will ultimately have to raise its target to 3%.

As an aside, I’m not sure we should pay much attention to this CPI report. First, we know that the cost of housing, a key formula input, is essentially contrived and is calculated with a huge lag. Thus, CPI is overstated. And second, the Bureau of Labor Statistics just changed the method of calculating CPI and Bloomberg News says that put upward pressure on January’s reading.

Taking a broader view, in all likelihood two key cycles are ending in 2023: inflation, and Fed tightening. Inflation peaked last summer and will continue to slow. And the Fed is pretty close to halting its rate hikes. Since these two factors were primarily responsible for 2022’s bear market, it’s no wonder the stock market hasn’t revisited October lows. Wharton finance professor Jeremy Siegel asks rhetorically, “Why is the stock market holding up?” The economy is stronger than it was a month ago, and the odds of a “no-landing scenario” are rising.