Another Fed Choice

The stock market's continuing concern about the health of the banking system suggests the Fed will have to make another choice besides whether to announce an upcoming pause in tightening -- whether or not to hike by 25 BP at the May 2-3 FOMC Meeting.  A hike would work toward achieving the Fed's 2% inflation target.  But, it also would exacerbate the banking system's problems, as discussed below.  The chances are the Fed will hike, hoping that regulatory actions will support the banking system.  But, it is also likely the Fed will announce a potential pause after this meeting.  The latter should be an important positive for the stock market.

Here are four negative effects of higher short-term rates on the banking system: /1/ Outflows of deposits to higher-yielding Treasury bills, /2/ Paper losses on longer-term mortgages and other debt held by banks, /3/ A loss in profits from "playing the yield curve" -- paying low short-term rates for funds and lending at higher long-term yields, /4/ lower demand for loans and other financial activities as the economy slows.  These are typical outcomes when the Fed tightens, and banks in the aggregate adjust by themselves to address this fallout.  So, the Fed could believe that the problematic banks are outliers that can be handled independently of monetary policy.

The primary focus of monetary policy, in this case, should be economic growth and inflation.  Here the evidence has not been overwhelmingly dovish with regard to Fed policy.  Although growth has slowed, the labor market is still tight and inflation too high.  Evidence on wage inflation has been mixed.  Friday's higher-than-expected Employment Cost Index (ECI) for Q123 showed no significant slowdown from the 2022 pace.  Nevertheless, this week's US economic data are expected to be soft, keeping open the possibility that the Fed will pause in tightening.

Consensus looks for an uptick in the April Mfg ISM to 46.7 from 46.3.  Such an uptick still would signal a sluggish manufacturing sector.  The Index has to exceed 48.7 to indicate growth.  The evidence is mixed, with Markit US Mfg PMI up for the fourth month in a row, while Phil Fed Mfg Index down in April.  More weight probably should be placed on the Markit Mfg PMI.  Recent history hints that it leads the Mfg ISM, while the decline in the Phil Fed Mfg may be catch up after it missed the direction of the Mfg ISM in March.  The Phil Fed Index often plays catch-up with Mfg ISM. 

Consensus also looks for Nonfarm Payrolls to slow to +180k m/m in April from +236k in March.  The evidence, however, is mixed regarding a slowdown or speedup in job growth.  The trend in Initial Claims is somewhat higher in April than in March, showing a modest increase in layoffs.  But, Continuing Claims did not rise as much as they did in March, suggesting hiring picked up, too. 

The Claims data support the consensus expectation of an increase in the Unemployment Rate.  Indeed, the data suggest it could rise by more than the 0.1% pt increase to 3.6% seen by consensus.   Besides the Unemployment Rate, a confirmation or not of March's jump in Civilian Employment could be important.  The jump could have resulted from the relatively small sample of this survey.  The April Report will tell whether the jump was an aberration or not.  

Consensus looks for a benign 0.3% m/m increase in Average Hourly Earnings (AHE), the same pace as in two of the past three months and not inconsistent with the Fed's 2% inflation target (taking account of the productivity trend).   There is no evidence.  A modest AHE probably shouldn't be dismissed because of the still high ECI.  There could be a shift toward lower-paid workers in the composition of employees, which the AHE would capture but the ECI not.  A compositional shift could hold down overall labor costs and help slow inflation.

Consensus expects Job Openings to fall to 9.6 Mn from 9.8 Mn.  This is in the right direction for the Fed, but the level is still well above the 7.5 Mn pre-pandemic trend.