Inflation pressures cool, economic outlook improves

The stock market rally that began in mid-June has been driven almost exclusively by the realization that the risk of the Fed over-tightening in order to fight inflation has declined meaningfully. That realization, in turn, has been driven by a growing body of evidence which points to a perceptible lessening of inflation pressures: an impressive slowdown in the growth of M2 this year (which I last documented here), a rather impressive selloff in the commodity markets (Chart #5 in this post), and a distinct cooling of the real estate market (a sudden slackening in housing demand has allowed mortgage rates to decline from 6% to 5% in just the last month). At the same time, there is very little evidence to suggest that the economy is in distress: swap spreads remain relatively low (i.e., liquidity is abundant, the opposite of what we would expect to see if monetary policy were actually tight), and credit spreads are only moderately elevated (i.e., the outlook for corporate profits remains healthy), and of course jobs growth remains robust (July job creation was surprisingly strong). 

In any event, the debate over whether the economy is in a recession hardly matters. If inflation is cooling, the Fed has no reason to raise rates until the economy collapses. If the bond market is right (and it usually is), then the Fed is likely to raise rates from today’s 2.5% to a peak of maybe 3.25% in the next 6 months or so, and that is simply not the stuff of which recessions are made.

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