Fed Policy Remains "Live"

The stock market's rally should not be derailed by Fed Chair Powell's threat of a rate hike at the July 25-26 FOMC Meeting.  First, it may not happen, as US economic data could soften sufficiently to satisfy the Fed that its forecast is on track without additional rate hikes.  Second, a 25 BP hike should not seriously damage the economy.

The most important point made by Fed Chair Powell at his news conference is that the July FOMC Meeting will be "live."  In other words, a rate hike at that meeting will be discussed and is a strong possibility.  Presumably, a rate hike will be decided on if evidence points to paths for the economy, labor market and inflation that are stronger than the Fed's Central Tendency forecasts.  Indeed, evidence of significantly slower growth, easier labor market and lower inflation may be required to persuade officials to pause next month.   Significant weakness in the data may persuade Fed officials that two more hikes will not be needed to achieve their forecasts -- in contrast to what they currently believe.  To be sure, this belief does not mean a hike in July is guaranteed, since the Fed will have more opportunities to do so in the rest of the year.  

The new information from major US economic reports ahead of the July FOMC Meeting will be the May PCE Deflator, June Employment Report and June CPI.  At this point, the risk is for all three to soften sequentially.  It is not clear, however, whether they will soften enough to keep the Fed on hold.  Moreover, evidence of slower growth and inflation from these key data may require support from other data, as well, such as rising Unemployment Benefit Claims and falling commodity prices.  A stronger dollar in the FX market could play a role in the Fed's decision, as well.  Note that the threat of further rate hikes, itself, should help boost the dollar and hold down commodity prices.

A slowdown in the Core PCE Deflator to 0.2-0.3% m/m in May from 0.4% in April is a reasonable expectation, based on the 0.4% May Core CPI.  More than 0.1% pt of the CPI's increase resulted from the jump in Used Car Prices.  These prices are essentially absent in the calculation of the PCE Deflator.  What appears to be the main reason for inflation remaining high is housing rent.  The Core CPI less Shelter and Used Cars has slowed each month since January and was only 0.1% in May.  The irony is that tighter monetary policy may work against a slowdown in rent by pushing people to rent rather buy a home.  Nevertheless, the CPI's measure of housing rent presumably will reflect the earlier sharp slowdown seen in private surveys at some point. 

Powell rightfully says that core inflation -- Total Less Food and Energy -- is better than overall inflation prints in indicating the underlying trend.   Nevertheless, Food and Energy Prices should not be dismissed entirely for being volatile.  Standard models say these prices influence wage inflation through inflation expectations and contract negotiations.  For example, high food inflation push labor to demand higher wages to offset the drag on spending power.  So, the stabilization of energy prices and the recent decline in food prices, seen particularly in the forward-looking PPI, are another reason, besides higher Unemployment, that could dampen wage inflation ahead. 

The Claims data indicate a softer labor market so far in June.  Initial Claims are 24k above the May average, as layoffs picked up.  Continuing Claims have turned back up.  At this point, the Claims data suggest a slowdown in June Payrolls.