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Chief Economist Eugenio J. Alemán discusses current economic conditions.

For more than six months, markets have been trying to figure out when the Federal Reserve (Fed) is going to start pivoting, that is, when is the Fed going to start decreasing interest rates. The markets know that more times than not, the Fed does what the market tells them to do. However, unlike markets, the Fed bases its decision on incoming data. And all the incoming data is suggesting that 2023 will be a long year, a year that will test the Fed’s commitment to keeping interest rates higher for longer as well as the markets’ resolve to convince the Fed to do otherwise and start pivoting before the end of the year.

The inflation graphs in the following pages show what Fed officials see in the inflation data today, which is very far from what it needs to see in order for it to start pivoting. However, markets don’t seem to be convinced of the Fed’s logic on that front. There is lots of speculation by markets that the Fed is going to start pivoting as soon as the U.S. economy enters a recession. And since economists have already penciled in a recession in 2023, markets believe that the Fed is going to start pivoting by the end of 2023.

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However, we disagree with markets on this one because even if the U.S. economy enters a recession in 2023, the Fed needs to be convinced that inflation is not going to come back if it starts to relax monetary policy. They cannot allow housing market lending to increase too much because they need home prices to go down considerably in order to keep inflationary pressures contained.

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So far, the housing component of CPI is still very high and has not started to decline because home prices, while they have been declining for several months, typically affect the housing component of CPI with a lag of about 12 months. Thus, our expectation is that housing prices will start to contribute to lower inflation through the housing component of CPI during the second quarter of 2023. Furthermore, recall that the housing component in CPI has a weight of about 33%, so its effects on CPI inflation are not trivial.

The Fed knows all this and will probably keep interest rates high until the housing component of CPI is well past its peak and already contributing to lower CPI inflation in order to guarantee that inflation is not coming back once it starts lowering interest rates. The Fed knows that if mortgage rates come down, housing affordability will increase, and ultimately home prices will start rising again, which is not what it wants in the battle to keep inflation down.

Furthermore, if we look at goods prices from the PCE price index in the graph below we see that although they have come down from their June peak of 10.6%, they are still running too hot for comfort. Meanwhile, services prices are also very high, and the Fed needs to guarantee that all the components of inflation are, once again, “well behaved,” in order to start lowering interest rates again, independently of how the economy is doing. Thus, the market’s assumption today that if the U.S. economy enters a recession in 2023, the Fed is going to start lowering interest rates is not the correct assumption even if recent history may say otherwise. In recent history, the Fed has not had to deal with such high rates of inflation, so it has had more latitude in bringing interest rates down faster once the economy weakens. However, that is not the case today.

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Taking a look at history, this means that services prices need to be between 2.0% to 4.0% and preferably on a disinflationary path, while goods prices will have to be close to 0.0% to 2.0% for the Fed to start pivoting. And this is probably not going to happen in 2023 unless the economy experiences several quarters of deflation, i.e., negative rates of inflation. Therefore, despite the market’s belief that the Fed will cut rates in the second half of 2023, we remain in the camp that the Fed will hold rates higher for longer as any premature loosening could lead to stickier inflation.

Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those of Raymond James and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur. Last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Statistics. Currencies investing is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample.

Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.

The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100.

Leading Economic Index: The Conference Board Leading Economic Index is an American economic leading indicator intended to forecast future economic activity. It is calculated by The Conference Board, a non- governmental organization, which determines the value of the index from the values of ten key variables

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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren’t part of this index.

FHFA House Price Index: The FHFA House Price Index is the nation’s only collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities that extend back to the mid-1970s.

Expectations Index: The Expectations Index is a component of the Consumer Confidence Index® (CCI), which is published each month by the Conference Board. The CCI reflects consumers’ short-term—that is, six- month—outlook for, and sentiment about, the performance of the overall economy as it affects them.

Present Situation Index: The Present Situation Index is an indicator of consumer sentiment about current business and job market conditions. Combined with the Expectations Index, the Present Situation Index makes up the monthly Consumer Confidence Index.

Pending Home Sales Index: The Pending Home Sales Index (PHS), a leading indicator of housing activity, measures housing contract activity, and is based on signed real estate contracts for existing single-family homes, condos, and co-ops. Because a home goes under contract a month or two before it is sold, the Pending Home Sales Index generally leads Existing-Home Sales by a month or two.

DISCLOSURES

Import Price Index: The import price index measure price changes in goods or services purchased from abroad by

U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).

ISM New Orders Index: ISM New Order Index shows the number of new orders from customers of manufacturing firms reported by survey respondents compared to the previous month.ISM Employment Index: The ISM Manufacturing Employment Index is a component of the Manufacturing Purchasing Managers Index and reflects employment changes from industrial companies.

ISM Inventories Index: The ISM manufacturing index is a composite index that gives equal weighting to new orders, production, employment, supplier deliveries, and inventories.

ISM Production Index: The ISM manufacturing index or PMI measures the change in production levels across the

U.S. economy from month to month.

ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers’ Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.

Source: FactSet, data as of 12/29/2022