Controlling Fear of the Fed

The stock and Treasury markets may need to see signs of a US economic slowdown to better control their fear of the Fed.  In particular, they may need to see evidence that the labor market is easing.  There are reasons to think this evidence will show up in coming weeks, including softer August Employment and Retail Sales Reports.  So, despite the somewhat hawkish July FOMC Minutes, the question of whether the Fed will hike 25 BPs at the September 19-20 Meeting remains open.

Although FOMC participants acknowledged an improving inflation picture in the July FOMC Minutes, they emphasized potential upside risks stemming from developments such as renewed supply chain problems, an upturn in commodity prices, and an insufficient slowdown in aggregate demand.  The strong start to Q323, as captured by the huge 5.8% (q/q, saar) early Real GDP Growth estimate of the Atlanta Fed model, may have focused the markets on this last risk.  

The strong start to Q323. however, does not mean strength will continue through the quarter.  For example, a large increase in Retail Sales, as in July, typically is followed by 2-3 months of softer sales.  Moreover, while the evidence from the Claims data is not yet complete, at this point it suggests a slowdown in August Payrolls (due September 1) and possibly an uptick in the Unemployment Rate.  Layoffs are up and hiring may have slowed.  Fed officials probably want to see more labor market slack to be less concerned about the inflationary consequences of strong aggregate demand.  

Besides softer real-side economic data, lower commodity prices also may be needed to assuage Fed officials and the markets.  As of now, these prices appear to be off their highs for the most part, but are still well above recent lows.  A decline in oil prices could be particularly important after they jumped in August.  It looks like the associated jump in gasoline prices will add significantly to the August Total CPI.  A sharp downturn in oil prices ahead of the CPI's September 13 release would allow the Fed and markets to dismiss the August jump as temporary.

Ironically, if the latest market turmoil helps slow the economy sharply, the markets may refocus on the other set of risks mentioned in the July FOMC Minutes -- a sharper-than-desired economic slowdown.  This turn of events, however, remains to be seen.