Like a prizefighter in the last reel of a boxing movie, inflation is hanging on the ropes and refuses to go down for the count.

Will the Federal Reserve go too far in its slugfest against inflation? The U.S central bank rarely gets it just right, and with hotter-than-expected inflation numbers last week, the danger is that higher interest rates will undermine the economic recovery.

Despite growing fears of a recession, the U.S. economy is showing remarkable signs of strength. Retail sales, the jobs market, and homebuilder sentiment are all on the upswing. Last week’s retail sales report was a blowout.

U.S. retail sales jumped 3% in January from the previous month, considerably higher than the 2% increase expected by the consensus of economists. That’s a reversal from the 1.1% decline posted in December, and the biggest rise since March 2021.

Strength in consumer spending is supported by a tight labor market, ample household savings, and solid wage gains. The headline unemployment rate in the U.S. has fallen to 3.4%. The last time unemployment was that low was way back in 1969, when as a kid I watched Neil Armstrong walk on the moon.

The curse of a strong economy…

Problem is, good news can sometimes be interpreted as bad news. The economy is gaining traction…too much so, for the Fed’s purposes.

The economy’s surprising resilience makes it more likely that the Fed’s interest rate tightening cycle will stay aggressive for longer. Hence the fear that the Fed will overdo it and cause gratuitous economic damage in its fight against inflation.

Does it make sense for a single agency to wield this much power over our economic lives? That’s another topic, for another day. Suffice it to say, Fed policy remains the dominant investment story.

To be sure, disinflation is still in effect. The consumer price index (CPI) continued its downward slope in January, but at a slower rate than expected. The same mixed dynamic emerged with the January producer price index (PPI), which showed signs of cooling off but not as much as Wall Street had hoped.

Amid this backdrop of good news/bad news, the equity markets generally dipped last week and the benchmark 10-year Treasury yield rose (see chart).

The strong jobs market is beneficial for American households, but it’s making some analysts nervous. Goldman Sachs (NYSE: GS) recently wrote that it now expects the Fed to hike rates three more times before the end of the year, each time by 25 basis points. Wall Street is currently pricing in a terminal rate of 5.3% by July.

However, technology stocks have rebounded despite the continuing risk of rising interest rates. As the above table shows, the tech-heavy NASDAQ has been in the vanguard of the stock market’s resurgence.

WATCH THIS VIDEO: 5 “Disruptive” Tech Trends of 2023

My view is that inflation will continue to ease, taking pressure off the Fed. Disinflationary trends are firmly in place, as supply chain woes heal and input costs (e.g., shipping rates) tumble. But inflation’s decline won’t be in a straight line and we’ll experience minor setbacks along the way. Hence the likelihood of persistent volatility this year.

The average analyst expectation is for the S&P 500 index to appreciate in price by at least 11% this year. Average year-over-year earnings growth in 2023 for S&P 500 companies is projected to reach nearly 4%. Those aren’t gangbuster numbers, but they’re certainly better than the dismal performances we suffered in 2022.

That said, renewed worries about inflation, recession, and Fed tightening are coming to a head. The main U.S. stock market indices started the holiday-shortened week with a sharp sell-off, closing Tuesday in the red as follows:

• DJIA: -2.06%
• S&P 500: -2.00%
• NASDAQ: -2.50%
• Russell 2000: -2.99%

All 11 S&P 500 sectors finished in negative territory. The benchmark 10-year U.S. Treasury yield spiked past 3.95%, its highest level since November. The CBOE Volatility Index (VIX), aka “fear index,” jumped nearly 7.50%.

The week ahead…

We face a slew of forthcoming economic data, especially on Friday:

S&P Purchasing Managers’ Indices for services and manufacturing, and existing home sales (Tuesday); minutes of the February meeting of the Federal Open Market Committee (Wednesday); initial jobless claims and first revision of fourth-quarter U.S. gross domestic product (Thursday); consumer spending, personal income, the personal consumption expenditures (PCE) price index, new home sales, and consumer sentiment (Friday).

Will we encounter a recession or soft landing in 2023? We’ll get a better idea when key economic reports, notably the PCE, hit the news wires.

The S&P 500 is coming off its second negative week in a row, as Treasury yields rise. Quarterly corporate earnings are still pouring in.

Before the opening bell on Tuesday, we got conflicting messages from two economic bellwethers. Home Depot (NYSE: HD) reported earnings that exceeded expectations but revenue that missed; Walmart (NYSE: WMT) easily beat on the top and bottom lines. Both retail giants offered muted guidance. Buckle up for a bumpy week.

Editor’s Note: If you pick your spots, you can still crush the broader market. That’s where my colleague Dr. Joe Duarte comes in.

Dr. Duarte has been a professional investor and independent analyst since 1990. He is a former registered investment advisor and author of the bestselling Options Trading for Dummies, and several other books including Market Timing for Dummies and Successful Biotech Investing.

Dr. Duarte is the chief investment strategist of our premium trading services, Profit Catalyst Alert and Weekly Cash Machine.

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John Persinos is the editorial director of Investing Daily.

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