Hey Janet - Inflation Lags, While The Stock Market Leads

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Includes: JNK, RINF, SPY
by: Lawrence Fuller

Summary

The Fed is focusing on employment and inflation data to determine changes in monetary policy.

The risk in this approach is that both employment and inflation are lagging indicators.

The Fed should be focusing on what financial markets are predicting in terms of inflation, employment and economic growth.

For an institution that emphasizes forward guidance, you would think that the Fed would focus on forward looking or leading indicators when making policy decisions, but based on recent commentary, it does not.

In a recent statement, the Fed asserted that "it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its two-percent objective over the medium term." In other words, the Fed will adjust policy based on incoming data.

Yesterday's inflation report was viewed as another step in that direction, as it revealed that consumer prices increased in October after declining in the previous two months. The Consumer Price Index increased just .2% over the trailing 12-month period through October, while the core Index, which strips out food and energy, increased 1.9%. Commentators suggested that this news would bolster the case for a rate hike by the Fed at its December meeting. I suspect that the hawkish members of the Fed feel the same way.

The problem with this incoming data is that it is a lagging indicator. Focusing on the latest inflation report as an indication of where the rate of inflation may be six months from now is as fallible as using the latest jobs report to determine how many new jobs will be created six months from now. Both employment and inflation are lagging indicators. They tell us more about where we have been, rather than where we are going to be at some point in the future.

Consider that the annual rate of core inflation peaked at 2.5% in August 2008, which was more than eight months after the last recession began. Looking back further, core inflation peaked in December 2001 at 2.8%, which was nine months after the prior recession began. Employment data operates with a similar lag in terms of where the economy stands in the business cycle when it is reported, yet this is the incoming data the Fed is focusing on.

If it wants to achieve and maintain its inflation and employment mandates, what the Fed should be focusing on is what financial markets are saying about economic growth. However, there is one problem. It has manipulated financial markets over the past several years in an effort to achieve its mandate of full employment and stable prices, thereby warping the predictive powers of what has historically been a discounting mechanism. I hope it recognizes this fact. The stock and bond markets have not been the leading indicators that they used to be before the financial crisis. Although there are now signs that this may be changing, I fear that some members of the Fed are not listening.

With respect to financial markets serving as discounting mechanisms, consider the message that the S&P 500 (NYSEARCA:SPY) was sending when it bottomed during the recession that followed the financial crisis. It closed at a bear-market low of 676 on March 9, 2009. From that point forward, it began a meteoric rise, despite the fact that the economic recession continued for four more months. The stock market led the recovery that was yet to come.

Before the Great Recession began in 2008, the S&P 500 peaked at its bull-market high of 1,561 on October 12, 2007. This was three months before what was the first contraction in economic activity in the first quarter of 2008. Again, the stock market led the contraction in economic activity that was yet to come.

This is what is meant by markets serving as discounting mechanisms or leading indicators. The movements in market prices today are discounting, or pricing in, future events. This can be seen in every asset class to varying degrees. It has long been my view that this discounting ability has been compromised for several years by the Fed's quantitative easing programs in combination with its zero-percent-interest-rate policy. Yet, it seems as though this may be changing with the incessant discussions of a change in policy. I think financial markets are slowly sobering up over concerns that they will not be bathing in free money for much longer. In light of these concerns, markets are again starting to discount developments in the real economy. This is happening at the same time that the Fed believes it has finally achieved its mandate.

The S&P Leveraged Loan index is currently at a four-year low. The SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK) peaked in value in May 2013. Both continue to decline gradually in value. It has been said that bonds are smarter than stocks, which is most certainly the case on the inflation front. The stock market indices are not far behind, as the S&P 500 peaked at 2,130 on May 21 of this year, despite continued monetary policy largesse. These are the kinds of indicators that the Fed should be placing more emphasis upon when making policy decisions.

I long for the day when we no longer have to spend time as investors worrying about what the Fed will, or will not, do. The reason that it is so important to do so today is that the game of investing has been fixed for some time. The referee on the field is the Federal Reserve, and it is the one that has been doing the fixing. It desperately wants to walk off the field and let the players play, but when it does so it is overly concerned about which side will win. Still, it needs to let the market work, so that the pricing mechanism of a free market can be reestablished. Once it does, then the market will be the ultimate judge of whether the Fed's policies have been successful or not. Then it will be a whole new ball game, and I want to be on the winning team.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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