Robust Retail Sales Recovery Gives Fed More Room to Raise Rates

The actual figure for US retail expenditure in January much above even the most optimistic projection, contrary to what economists had anticipated. Yet, for the time being, the Federal Reserve’s vigorous campaign to manage inflation by lowering economic activity is failing. 

Retail sales spiked 3.0% last month after reports that payrolls increased significantly in January. Notwithstanding the Fed’s hawkish policy move that has aggressively raised interest rates over the past 11 months, the two data indicate that the American economy will be resilient at the start of 2023.

The strength of January’s retail sales and payrolls contrasts with a number of broad business-cycle indicators that show a sluggish economy. For instance, the Leading Economic Index for December from the Conference Board indicates that the US is in a recession. In addition, a survey-based GDP substitute, the US Composite PMI, likewise shows that the economy shrank in January.

Yet, if problems is developing, it is not readily apparent in the payroll and consumer spending numbers from last month. The contrast is so dramatic that it hardly seems possible. Which profile is correct, that is the question. According to the bond market, which is once again moving towards the idea that monetary policy will need to remain tighter for longer to control inflation, the policy-sensitive 2-year Treasury yield is once again pushing higher.

The consumer price index data for January showed a slower decline than anticipated, which suggests that the Fed’s efforts to speed up the disinflationary process aren’t having the desired effect.

Yesterday (Feb. 15), the 2-year rate increased a tad, rising to 4.63%, barely shy of the prior peak of 4.72% in November, which continues to be the highest level since 2007.

The 2-year rate has recently increased and is now above the effective Fed funds rate of 4.58%, which indicates that the market may be readjusting its forecast for a higher terminal rate than first anticipated for the central bank’s raising cycle.

The expectation for interest rates may also be changing according to Fed funds futures. According to CME data, concentrating on the highest indicated Fed funds probability in each of the upcoming three FOMC meetings points to a path that raises the current 4.5%-4.75% range to 5.25%-5.5% by the June 14 meeting.

Is the economy more accurately represented by the January numbers on retail sales, payrolls, and inflation? Or do other indicators that portray a weaker profile and follow the general economic trend accurately reflect reality?