Week in Review: March 17, 2023

Inflation remains too high; all eyes shift to next week’s Fed decision

Market summary

U.S. equities were mixed this week, as economic and market uncertainty grew. From a style perspective, growth significantly outperformed value. Treasuries were significantly firmer with the curve steepening. The 2-year yield fell below 3.7% during the week, before ending the week near 3.8%, while the 2-year to 10-year spread notably narrowed after inverting the most since 1981 last week. The dollar index ended the week lower.

This week

February’s inflation release highlights that inflation remains too high. While the increase in February was less than in January, the fact remains that inflation is running above what the Federal Reserve (the Fed) is comfortable with. February’s Consumer Price Index (CPI) rose by 0.4% month over month (MoM) at the headline level, after rising by 0.5% in January, and rose by 6% year over year (YoY). Energy prices fell by 0.6% MoM, declining for the third time in the past four months. The larger decline in household utility prices offset an increase in gasoline prices, and we anticipate energy prices will fall further in upcoming months. We expect inflation will moderate in 2023 but will take longer for inflation to get closer to the Fed’s 2% goal. 

Core CPI (excluding food and energy) increased by a stronger 0.5% MoM in February and by 5.5% YoY, following a 5.6% YoY increase in January (see Figure 1). The shelter component drove most of the rise in core CPI; shelter was up by 0.8% in February, surpassing January’s 0.7% gain. Shelter prices will soften markedly in the second half of the year, as there’s roughly a 9- to 12-month lag between market rents and the shelter component of CPI. Various market-based measures for rents point toward the CPI for rents declining in 2H 2023. We believe, in 2H 2023, we’ll see these declines in the shelter component of inflation trickle in and help move inflation closer to the Fed’s target.

Core services inflation, which is the stickier side of the inflation picture that the Fed is now much more focused on slowing, remains resilient, driving the increase in headline inflation. Core services prices were boosted by a 0.8% MoM rise in the shelter component, after rising by 0.7% MoM in January (see Figure 2). The persistence of core services inflation will keep the focus squarely on the labor market. Services prices are largely determined by the domestic economy, particularly the labor market and nominal wage growth. Job growth momentum has moderated but isn’t slow enough to meaningfully cool services inflation. 
February’s Producer Price Indexes (PPIs) came in softer than expected, which is welcome news for the Fed’s fight against inflation. Producer prices fell by 0.1% MoM, after rising by 0.3% the prior month. The headline PPI fell to 4.6% YoY from 5.7% the prior month, the lowest level since March 2021. Producer prices were driven lower by declines in non-core food components, which were driven lower by a 36.1% decline in egg prices. The MoM decline in February coupled with the downward revision to January’s increase shows that slowing demand is leading to a further slowdown in price increases, especially for the goods sector. 

Retail sales fell by 0.4% MoM in February, after rising by 3.2% MoM in January (see Figure 3). In February, spending was mixed across most of the retail sales sub-components. Spending at food services and drinking places fell by 2.2%, illustrating less willingness to spend on discretionary services. We also saw declines on big-ticket items, including motor vehicles and furniture, but losses were partly offset by gains in other areas of the consumer basket. Consumer spending appears to have moderated ever so slightly in February and remains well above its historical trend. Control group retail sales (excluding autos, gasoline and building materials), which feed directly into gross domestic product (GDP), rose by 0.5% MoM in February. While there was a decline in the core “control group” of retail sales from January to February, the decline isn’t enough and indicates that consumers are hanging in there for the time being. 

This week, bond market volatility moved significantly higher as the upcoming Fed meeting next week gets closer. There was significant movement across the U.S. Treasury curve, but the short end of the curve was the most volatile. The MOVE index, which measures volatility of the entire treasury yield curve, reached a level of 174 on Monday, the highest level since 2008. The volatility in the bond market compounded with financial markets’ stress showed up in the Fed’s weekly balance sheet release, with outstanding emergency loans standing at $318 billion yesterday, up from $15 billion a week earlier. While $318 billion is a large number, it’s below the high during the Global Financial Crisis, when we saw outstanding emergency loans hit almost $450 billion in 2008. The increase in bond market volatility coupled with the stress about financial stability make the Fed’s rate decision more challenging. The recent uptick in financial stability risk has coincided with the Fed’s blackout period for commentary before next week’s Federal Open Market Committee (FOMC) meeting, so we don’t know how increased financial stability risk is going to play into its decision on rates. Regardless of the outcome at next week’s FOMC meeting, we believe that there will be a pause in rate hikes, as the Fed will need to monitor the financial stability situation.

THE WEEK AHEAD

• February’s existing home sales are expected to increase to 4,185,000 and will be released on Tuesday. 
• At the Federal Open Market Committee meeting on Tuesday and Wednesday, the Fed will provide details about upcoming changes in monetary policy. 
• February’s new home sales are expected to decline to 635,000 and will be released on Thursday.  

Figure 1: U.S. core CPI (YoY percentage change)

 
Sources: Bureau of Labor Statistics, First Republic Investment Management, as of March 17, 2023.

Figure 2: U.S. retail sales by category (monthly percentage change)

 
Sources: Bloomberg, First Republic Investment Management, as of March 17, 2023.

Figure 3: U.S. core CPI commodity and services (YoY percentage change)

 
Sources: Bloomberg, First Republic Investment Management, as of March 17, 2023.

Market Returns (USD) as of 3/16/2023

Market Levels