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Growing worries about Fed-born recession brings Wall St its worst week in months

The Federal Reserve finally pared back its interest rate hikes, but markets were less than happy the central bank is still cutting rates and are worried it may be driving the U.S. economy into a recession for 2023.  

MANHATTAN (CN) — Despite persistent messaging from Federal Reserve Chair Jerome Powell that the central bank will use myriad interest rate hikes to achieve a soft landing to inflation, markets are worried the Fed’s efforts may instead have set the stage for stagflation.

It is widely believed the U.S. economy will slip into a recession during the first half of the year in 2023. Just how mild the recession will be, however, is up for debate.

Tom Essaye of the Sevens Report wrote in an investor’s note Friday morning that “despite the improving [inflation] data released earlier in the week, the sharp drop off in growth is outpacing the slowing rate of inflation pressures, especially in the U.S.”

He said Wall Street has transitioned from paying primary attention to the Fed to now focus almost entirely on growth and inflation. “Between now and year-end, however, we shouldn’t be shocked by a continued selloff as investors, who were hoping for a Santa Claus rally, are largely ‘throwing in the towel’ and instead focusing on harvesting tax losses,” Essaye wrote.

The most notable drop in equities came on Thursday when the Dow Jones Industrial Average shed 764 points — at one point dropping more than 900 points — and the S&P 500 and Nasdaq suffered similar tumbles. Those losses continued on Friday with the Dow losing 556 points for the week, while the S&P 500 fell 82 points and the Nasdaq declined 299 points.  

The big news of the week was the Fed’s announcement on interest rates. Such announcements over the past year have at times buoyed markets looking for indications the Fed would soon slow its war on inflation, but this latest announcement to raise interest rates by only half a percentage point, after four consecutive 0.75% hikes, did not turn markets around.

Instead, investors were more attuned to the “dot plot” in the accompanying economic projections, which shows the majority of the Fed’s governors are inclined to keep rates steady throughout next year rather than start cutting them. Not only that, but most governors seem to favor an additional 0.75% of interest rate hikes at some point in 2023.

Powell quite infamously was caught flat-footed in dealing with inflation in 2021, having initially called price changes “transitory” before acknowledging they were likely to persist. Ever since, the Fed has remained laser-focused on reducing decades-high inflation through a series of aggressive rate hikes, even if it stymied growth, in an effort to maintain price stability.

The current federal funds rate sits at 4% to 4.25%, though the Fed indicated it could raise rates to 5% to 5.25% next year, about half a percentage point higher than most initially had anticipated.

“The economy isn’t in recession yet, but as long as the Fed is aggressively raising interest rates it’s going to be hard for it to retain its resilience and the chances of a soft landing will go down proportionately with the Fed’s willingness to let up on rate hikes,” Chris Zaccarelli, chief investment officer for the Independent Advisor Alliance, said in a statement on Wednesday. “The Fed is taking away the punchbowl just as the party was getting started.

Other data points this week were mixed. On Wednesday, the U.S. Bureau of Labor Statistics’ consumer price index showed prices increased only by 0.1% last month, well below the consensus forecast of 0.3%. Core prices gained only 0.2%, while gasoline prices saw a 2% decrease month-over-month.

“Inflation should be much less of a problem for the U.S. economy in 2023,” said Bill Adams, chief economist for Comerica Bank, adding that “a weakening economy” has also cooled inflation somewhat. “Consumers have had to tighten their belts as the cost of living rose and stimulus money ran out.”

The U.S. Census Bureau’s monthly retail sales data this week showed consumers pared back their spending in November by $689 million, a 0.6% drop from the prior month. This was worse than the 0.2% decline many experts expected, though it was offset by the revised 1.3% gain in retail sales seen in October.

Falling gasoline prices were largely blamed for the overall drop on retail, but some sectors fared worse than others. Manufacturing saw a 0.6% decline, while spending on big-ticket items — such as furniture and cars ‚ fell the most. One positive surprise was in utilities output, which gained 3.6% after large drops the three prior months.

Some experts said the report wasn’t all that bad, though, pointing out that so-called “control retail sales” — or those that excluded sales of motor vehicles and their parts, as well as retail at gasoline stations — declined only 0.2% in November.

“The details of November retail sales are better than the headline suggests and further evidence that the economy has momentum heading into 2023,” Oren Klachkin at Oxford Economics wrote in an investor’s note. “Consumers remain in a spending mood, but the tide will gradually shift over the coming months as income growth cools, lingering excess savings dry up, and negative wealth effects from lower stock and house prices come to bear.”

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