The inflation outlook is complicated by the goods sector (including housing and autos) cooling down, and the service sector, including the labor market, still overheating.
With the service sector making up 2/3 of the economy, the Fed is likely worried that goods inflation may be coming down, but service sector inflation continues to rise, see chart below.
The bottom line is that we will need to see a meaningful softening in the labor market for the Fed to slow down the speed of rate hikes. This is not expected in today’s employment report, where the consensus sees headline nonfarm payrolls growing at 300K, wage inflation rising to 5.3%, and the unemployment rate staying steady at 3.5%, the lowest level in over 50 years.
In short: As long as hiring remains strong and wage growth remains high, the Fed will keep raising rates, and equities and credit will be under pressure because of the negative impact of higher wage and cost inflation on margins. And once the labor market starts softening, the market will turn its attention to the speed of the softening and whether it is a soft landing or a hard landing, i.e. a recession.
For investors, the implication is that we need inflation to come down from 8.5% and closer to the Fed’s 2% target, and we need a soft landing in the labor market before we can get a sustained rally in equities and credit.
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