Key Takeaways
- Wall Street has become less welcoming of “bad” economic data in recent weeks, as a weakening labor market and slowing inflation have altered views that took hold during the U.S.’s post-COVID boom.
- After years of focusing on controlling inflation, the Fed has begun to emphasize growing risks to maximum employment: the second element of its dual mandate.
- The change comes as markets prepare for the Federal Reserve to begin cutting interest rates next month for the first time in more than four years.
As the Federal Reserve began raising interest rates to combat soaring inflation in 2022, a new paradigm took hold on Wall Street: “bad data” is good news.
The U.S. economy was growing at about 7% annualized rate as of the end of 2021, the fastest pace in the past two decades, excluding a 33% COVID-19-induced increase in the third quarter of 2020. American consumers, the driving force behind the U.S. economy, emerged from coronavirus lockdowns flush with savings and ready to spend.
But this economic boom has been a double-edged sword: annual inflation rose from 1.4% to 7% between January and December 2021. Inflation has continued to rise, reaching 9.1% in June 2022, the highest since the 1980s.
The Federal Reserve is focused on inflation and launched its most aggressive interest rate hiking campaign in decades in March 2022 to prevent the US economy from collapsing.
With the labor market historically tight, the Fed’s focus may become single-minded, despite a congressional mandate to control both inflation and unemployment.
Hiring halted in March 2020 as businesses across the country closed and offices were shuttered due to the coronavirus. But as the economy recovered and rock-bottom interest rates stimulated growth, companies rushed to hire. In 2021, employers added an average of 603,000 jobs per month, and the unemployment rate fell from 6.4% in January to 3.9% in December. However, as of March 2022, there are still more than 12 million job openings in the U.S., nearly double the number before the pandemic.
The labor market is expected to remain unusually tight through 2022 and 2023, and wage growth will remain well above pre-pandemic averages, thereby supporting consumer spending and growth.
And for a while, signs of a weakening job market and a slowing economy were good news for the Fed and the markets, because inflation was the Fed’s biggest risk.
Inflation is no longer a top concern
All that has changed in the last few weeks.
Stocks had their worst day since 2022 in early August after the July jobs report showed an unexpected rise in the unemployment rate, raising concerns that the labor market had not just softened but worsened and the economy could slip into recession. Just a few days later, stocks had their best day since 2022 after initial jobless claims came in lower than expected.
Inflation has lagged behind other economic indicators: Earlier this month, the S&P 500 index had its strongest reaction to growth data since 2020, according to a new report from Bank of America Securities. Meanwhile, the index’s reaction to inflation data was its most muted since January.
“Growth is leading the charge,” Bank of America analysts concluded.
And strong growth has stopped scaring the market, as reflected in the chart below, where LPL Financial strategists Adam Turnquist and George Smith chart the correlation between the S&P 500 and the Bloomberg U.S. Economic Surprise Index. They note that a positive correlation means good economic news is good news for Wall Street, while a negative correlation means the opposite.
LPL Financial
Over the past year, the correlation between the two has fluctuated between negative and positive, but has been negative for longer periods of time, and the most severe negative correlations have been greater than the most severe positive correlations.
The correlation turned positive in early August, which could be a sign that “investors may no longer be skeptical of the economy,” Turnquist and Smith wrote.
Fed steps up focus on labor market
The Federal Reserve has also stopped viewing the economy as doubtful. “The economic outlook remains uncertain, and the Committee continues to pay close attention to inflation risks,” the Federal Open Market Committee’s (FOMC) June policy statement read. In July, the sentence became, “The economic outlook is uncertain and the Committee is mindful of risks to both sides of its dual mandate.”
Minutes from the Fed’s July meeting released on Wednesday showed officials growing concern about the state of the labor market. “Participants saw risks to achieving their inflation and employment objectives as continuing to become more balanced, with several saying they viewed these risks as more or less balanced,” according to the minutes.
“Upside risks to inflation have decreased, while downside risks to employment have increased,” Fed Chairman Jerome Powell said Friday in a highly anticipated speech at the Fed’s annual Jackson Hole Economic Policy Symposium. As a result, “it is time to adjust policy,” Powell said, noting that the pace of monetary easing will depend on upcoming data.
Markets nervous ahead of September rate cut
Wall Street has been waiting for interest rate cuts for most of this year, but now that a cut seems increasingly imminent, a sense of foreboding may be in the air.
“Are markets really so worried about the labor market that they’re asking the Fed to cut rates?” asked Quincy Krosby, chief global strategist at LPL Financial. To an extent, yes. “Because what the market doesn’t want is for the Fed to ignore it, to see the labor market worsen and do nothing.”
“But it also suggests the economy is slowing at a faster pace than markets thought,” she added.
Bank of America analysts argue that what the market really wants is assurance that the central bank won’t sacrifice economic expansion to rein in inflation. “All the stock market needs is confidence that economic growth will be supported by the Federal Reserve,” they wrote.
In Powell’s words, the Fed’s response to easing depends on “the full set of data,” and there’s a lot of data between now and the Fed’s next meeting on Sept. 18, including two inflation reports and the August jobs report.
