Key Takeaways

Starting in 2022, around the time the Federal Reserve began raising interest rates to combat surging inflation, a new paradigm took hold on Wall Street: “Bad data” was good news.

The U.S. economy was growing at an annual rate of nearly 7% at the end of 2021, its fastest pace in two decades—excluding the Covid-induced 33% jump in Q3 2020. U.S. consumers, the engine of the U.S. economy, were spending hand over fist as they came out of Covid lockdowns flush with savings.

But the economic boom was a double-edged sword. From January to December 2021, the annual inflation rate climbed from 1.4% to 7%. It would continue to rise before peaking in June 2022 at 9.1%, its highest since the 1980s.

The Federal Reserve homed in on inflation and, in March 2022, began its most aggressive campaign of interest rate hikes in decades as it sought to keep the U.S. economy from boiling over.

The Fed’s focus could be singular, despite a Congressional mandate to manage both inflation and unemployment, because of a historically tight labor market.

Hiring ground to a halt in March 2020 as Covid-19 shuttered businesses and closed offices across the country. But as the economy recovered and rock bottom interest rates stimulated growth, companies went on a hiring spree. Employers added an average of 603,000 jobs a month in 2021, reducing the unemployment rate from 6.4% in January to 3.9% in December. And yet in March 2022, there were still more than 12 million job openings in the U.S., nearly double the pre-pandemic level.

The labor market remained abnormally tight throughout 2022 and 2023, keeping wage growth well above the pre-pandemic average and subsequently supporting consumer spending and growth.

And so for a while, evidence of a weakening job market and slowing economy was good news for the Fed and markets, because inflation was the Fed's biggest risk.

Inflation is No Longer the Main Concern

That has all changed in recent weeks.

Stocks had their worst day since 2022 in early August after July’s jobs report showed a surprising jump in the unemployment rate, raising fears that the labor market had not just softened but deteriorated and that the economy was on track to slip into recession. Just days later, initial jobless claims came in lower than forecast and stocks had their best day since 2022.

Inflation has taken a back seat to other economic data points. The S&P 500 earlier this month had its biggest reaction to growth data since 2020, according to a recent report from Bank of America Securities. Meanwhile, the index’s response to inflation data was its most muted since January.

“Growth,” BofA analysts concluded, “is in the driver’s seat.”

And strong growth has stopped scaring markets, as reflected in the below visualization by LPL Financial strategists Adam Turnquist and George Smith, who charted the correlation between the S&P 500 and the Bloomberg U.S. Economic Surprise Index. A positive correlation, they note, implies that good economic news is good news on Wall Street, while a negative correlation implies the opposite.

The two have oscillated between negative and positive correlation over the last year, though they have spent more time negatively correlated. The negative correlation at its most severe has also been greater than the positive correlation at its most severe.

The correlation turned positive in early August in what could be a sign, Turnquist and Smith write, that “investors may no longer be giving the economy the benefit of the doubt.”

Fed Increasingly Focused on Labor Market

The Fed also has stopped giving the economy the benefit of the doubt. “The economic outlook is uncertain, and the Committee remains highly attentive to inflation risks,” the Federal Open Market Committee’s June policy statement read. In July, that sentence became: “The economic outlook is uncertain, and the Committee is attentive to the risks to both sides of its dual mandate.”

The minutes of the Fed’s July meeting, released on Wednesday, indicated officials were increasingly concerned with the state of the labor market. According to those minutes, “Participants saw risks to achieving the inflation and employment objectives as continuing to move into better balance, with a couple noting that they viewed these risks as more or less balanced.”

On Friday, in an eagerly anticipated speech at the Fed's annual Jackson Hole Economic Policy Symposium, Fed Chair Jerome Powell said, "The upside risks to inflation have diminished. And the downside risks to employment have increased." As a result, "The time has come for policy to adjust," Powell said, noting that pace of monetary easing would depend on incoming data.

Markets on Edge Ahead of September Rate Cut

Wall Street has been eagerly awaiting interest rate cuts for most of this year. But now that those cuts finally appear imminent, they may also feel ominous.

“Does the market really want the Fed to cut interest rates because they’re worried about the labor market?” asked Quincy Krosby, Chief Global Strategist at LPL Financial. To a certain extent, yes, “because what the market doesn't want is the Fed to neglect that—just see deterioration in the labor market and do nothing about it.”

“But,” she added, “it also then suggests that the economy is slowing at a faster pace” than the market thought.

What markets really want, BofA analysts argue, is reassurance that the central bank won’t sacrifice economic expansion to tame inflation. “Equities just need a nod that growth is going to be supported by the Fed,” they wrote.

Whether the Fed accommodates will depend, in Chair Powell’s words, on “the totality of the data.” And there’s a lot of data—two separate inflation reports and the August jobs report—between now and the Fed’s next meeting on September 18.

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