Good news still isn’t good, yet

Investors are processing how a strong labor market reconciles with the Fed’s efforts to slow the economy to reduce inflation.

The Fed made headlines last week as it took another step toward slowing the economy to ease inflation. Chairman Jerome Powell announced an additional increase in the Fed’s policy interest rate and declared future rate hikes would be necessary to create an economic environment “sufficiently restrictive” to reduce inflation. Shortly after the announcement, the stock market rallied and broad market indexes gained ground.

Then, just two days later, the job market made a splash of its own as a report revealed the economy added a whopping 517,000 jobs in January. The same report showed that the unemployment rate has fallen to its lowest level since 1969. But rather than celebrate the news of this hiring spree, investors pulled back and broad market indexes shed much of the gains accumulated in the days before.

In today’s economic reality, it seems like bad news is good and good news is bad. This can be confounding for those trying to make sense of it all. To understand more about what’s driving this, we need to dig a little deeper into the data (a review of my prior post on The Waterwheel might help).

The latest employment report is undoubtedly an indication that the labor market is strong, but it’s important to note that not all sectors are hiring in the same way. Service industries in particular—such as leisure and hospitality, education and healthcare, and professional services—are responsible for the bulk of new jobs added to the economy in January.

The rapid hiring in service industries is a direct response to how consumers have been spending. While spending is slowing on the whole, people are directing a larger share of their budgets toward services—like hotel rooms, restaurant dining, and doctor’s appointments—and away from physical goods. So, service-oriented businesses are adding to payrolls because of changes in consumer demand.

Importantly, this reallocation in household budgets is also driving trends in inflation. While overall inflation declined from November to December, not all sectors are seeing prices fall in the same way. The latest decrease in inflation was mostly due to falling prices for energy and physical goods, while the price of services continued to increase on a monthly basis.

Services tend to be labor intensive, which means they are sensitive to changes in the cost of labor. As hiring increases in these sectors, so too do wages, and some of these costs are passed on in the form of price increases. This is why the Fed has services in its crosshairs as it continues to battle inflation.

Investors are hoping that the Fed will succeed in its effort to reduce inflation. As Mr. Powell mentioned in his press conference following the most recent rate increase, lower inflation is necessary for an economic environment that works for everyone. And the sooner inflation resumes more typical levels, the sooner the Fed can stop slowing the economy and start accommodating economic growth again. When investors sense progress is being made toward this end, markets tend to rally.

Indeed, there are some signs that the Fed might be making progress toward its goal, as consumer spending has eased and the overall price level is falling. But inflation remains much higher than the Fed’s stated 2% target, and Mr. Powell also stated that the Fed needs “substantially more evidence” before it abandons its restrictive policy stance. Unfortunately, the 517,000 new jobs last month were actually evidence that would support the Fed’ efforts to further slow the economy, as the most robust hiring gains happened to come in sectors which pose the most significant challenge to inflation. When investors see evidence contrary to the Fed’s progress in fighting inflation, markets tend to recoil.

Markets are volatile and reactive right now in today’s environment of heightened uncertainty. While developments in the macroeconomic story are important, it’s more important for investors to tune out the daily noise and stay focused on the more predictable long-term potential of the U.S. economy and its capital markets.