The broader indices bounced back strongly last week, with the S&P 500 rallying 3% from last Monday’s close. Now, we saw a bit of a dip again yesterday, but this morning is turning around strong again. There are a lot of factors contributing to these gyrations. In today’s blog, we’ll take a look at a few of them. In particular, the latest from the Federal Reserve, inflation and my outlook for interest rates in the near term.
First off, we finally heard from new Fed Chairman Jerome Powell last week, and as expected, he attempted to calm the financial markets. He noted that the Fed "will remain alert" to any risks in financial stability, as well as stated that the Fed will gradually normalize its interest rate policy and shrink its balance sheet.
This helped placate Wall Street a bit, especially in light of brewing inflation. The Labor Department reported last week that CPI surged 0.5% in January. That was well above economists’ forecast for a 0.3% rise. Even when you exclude food and energy prices, core CPI increased 0.3% last month, which was also higher than estimates for 0.2%. In the past 12 months, the CPI is now running at a 2.1% annual pace, a bit above the Fed’s 2% inflation target. But remember, the Personal Consumption Expenditure Index is the Fed’s favorite inflation indicator, not the CPI.
The Labor Department also reported that the Producer Price Index (PPI) rose 0.5% in January, which was not a surprise due to higher energy prices. However, the big surprise was that the core PPI, excluding food, energy and trade, also rose 0.4%. In the past 12 months, the PPI has risen 2.7% and core PPI rose 2.5%, so wholesale inflation is now clearly brewing. The only hope to squelch this wholesale inflation will be a stronger U.S. dollar to push down commodity prices and moderating energy prices.
Interestingly, the inflation caused by higher prices at the pump may be fleeting, since crude oil prices continue to moderate as the U.S. ramps up its shale oil production. The Energy Information Administration (EIA) recently reported that U.S. shale crude oil production is expected to rise by 110,000 barrels per day in March. In addition, the proposed U.S. budget deal includes the sale of 100 million barrels of crude oil from the Strategic Petroleum Reserve, which represents about 15% of the current storage. Overall, the EIA is forecasting that the U.S. crude oil production will average 10.3 million barrels per day in 2018 and 10.8 million barrels a day in 2019. If achieved, that will rival both Russia and Saudi Arabia for the top producer of crude oil.
The bottom line: Inflation is clearly brewing in the near term, and you can bet the Fed will take that into consideration at its March Federal Open Market Committee (FOMC) meeting. Considering this and market rates, I look for the Fed to raise key interest rates at its March meeting. But after that, the potential for further interest rate hikes this year will drop off.
That’s partly because the CPI report also showed that inflation adjusted wages declined 0.2% in January. This is concerning for the Fed, since it likes to see wage inflation before increasing rates. Also, the Commerce Department reported that retail sales fell 0.3% in January, which is the largest monthly drop in nearly a year. December retail sales were also revised down to "unchanged" from a previous estimate of a 0.4% increase. As a result, economists are now trimming both their fourth-quarter and first-quarter GDP forecasts due to a rapid deceleration in retail sales.
So, these are all factors that the Fed will consider at its next FOMC meeting and before raising key interest rates multiple times this year. Overall, I think we can assume that the Fed will not let interest rates rise too much, too fast.