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Inflation was a big problem last year and inflation-fighting policies had a big, negative effect on stock and bond prices in 2022. Inflation will continue to be a front-and-center Issue for investors this year. 

Course Correction Needed was the title of the second section of my September newsletter. In that section, I wrote: “Until market participants sense a course correction in the inflation / interest rates / Fed policy dynamic, stocks are likely to struggle”.

I’m pleased to report that a course correction is under way. Inflation gauges are generally improving, longer-term interest rates made a meaningful adjustment, and the Federal Reserve has slowed its pace of short-term interest rate increases.

On February 2, the Fed brought its target for short-term interest rates up to 4.75%, an increase of 0.25 percentage points. This follows a 0.5 percentage point increase in December, and a series of 0.75 percentage point increases last fall and summer.

This indicates we may be approaching the end of the ‘Fed tightening cycle’ that I discussed in my October 2022 newsletter.

Improvements in inflation and a ‘go-slower’ Fed have given a very significant lift to stock and bond prices so far this year. Can this course correction persist in 2023?

The answer is yes, but likely will require the labor market to come off the boil.

The jobs market was hot in 2022. There were 4.5 million new jobs created last year, and millions of job openings remained unfilled.

This supply / demand gap in the labor market was a key factor that drove wages higher, which in turn contributed to inflation.

The hot labor market persisted in January. US employers added 517,000 jobs and the unemployment rate declined to 3.4% – the lowest since 1969. This is good for workers and good for economic growth. But for inflation? Not so much.

We should recognize the improvement in the financial markets in the early weeks of 2023 as a benefit for portfolios.

But we should also realize that the process of course correction is more likely to look like a winding mountain path, with sections of rocky trail and switchbacks, than a straight, paved road back to satisfactory investment results.