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.

 

A Summer Rally After A Fed Pause?

A Fed decision to pause in rate hikes at this week's FOMC Meeting may be met by some profit-taking in the stock market, but it will help set the stage for a summer rally.  A pause would signal that the Fed wants to keep the cost of reining in inflation low, allowing the latter to be achieved through slow growth rather than recession.   Moderating inflation along with modest economic growth should be a positive for stocks.  This week's US economic data may very well point to such a combination.  

This week's inflation data risk being on the soft side.  To be sure, consensus looks for a still-high May CPI, with +0.2% m/m Total and +0.4% Core.  But, there is downside risk to both, as I mentioned last week.  Moreover, there is room for a further slowdown in Core in coming months through a slowdown in the CPI's measure of housing rent.  The moderation in labor costs (see last week's blog) and commodity prices, as well as the somewhat stronger dollar (the effect of which could show up in this week's May Import Prices release), bode well for an inflation slowdown ahead, as well.  Consensus also looks for a benign May PPI, with -0.1% m/m Total and +0.2% Core.

This week's real-side data are expected to show slow, but positive growth.  Consensus expects May Retail Sales to dip 0.1% m/m in Total but increase 0.1% Ex Auto, after +0.4% for both in April.  There is some upside risk, reflecting the tendency for sales to recover from a very weak period for several months (sales fell in February and March).  Also, news reports of good mall traffic over the Memorial Day weekend may show up in the figures.  Another report regarding the consumer will be the Mid-June University of Michigan Consumer Sentiment Index.  Consensus sees an uptick to 60.5 from 59.2 in May.  The more important part of the survey will be the 5-Year Inflation Expectations.  The question is whether they  return to their 2.8-3.0% range after rising to 3.1% in May.  A return would assuage fears that longer-run inflation expectations are becoming unhinged.

Consensus also looks for a 0.1% m/m increase in May Industrial Production.  The risk is for Manufacturing Output to edge up, as well, based on Total Hours Worked.  An increase in the latter would put the April-May average about 2.0% (saar) above the Q123 average, raising doubt about the significance of the weak manufacturing surveys seen in recent months.

Stock Rally Should Continue -- Good News on Wage Inflation

The stock market's pullback lasted one day last week, ending after top Fed officials signaled the likelihood of a pause in rate hikes at the June 13-14 FOMC Meeting.  A pause should bolster economic growth.  At the same time, inflation may remain contained, as surprisingly softer data on the wage front were released last week.  Slower wage inflation supports a Fed decision to pause and could help lift corporate earnings.  In all, the latest macroeconomic developments should help sustain the stock market rally.

There were several "good" pieces of evidence regarding wage inflation last week.  There was a large downward revision to Compensation Per Hour in a report the market typically ignores.  Wage inflation in the May Employment Report eased back to a moderate trend despite a surge in jobs, and the high April wage print was revised down. 

Major downward revisions to Compensation/Hour -- the broadest measure of labor costs -- significantly lowered upside risks to inflation (see table).  Rather than showing an acceleration in the trend of labor cost inflation, as the prior preliminary data had shown, the revised data show a slowdown to a 3.0% or lower pace consistent with the Fed's 2% price inflation target -- taking account of an uptrend in productivity.  

                                            Compensation/Hour (percent change)

                                      (q/q, annualized)                     (From a Year Ago)      

                                    Revised        Prior                    Revised        Prior

        Q123                   2.1                3.4                         3.0                5.0       

        Q422                  -0.7               4.9                          3.0                4.5           

The May Employment Report had a lot of favorable features for the Fed and stock market, besides a slowdown in wage inflation.  Although Payrolls surged (which was the risk), other parts of the Report were benign.   Despite the jump in jobs, Total Hours Worked (THW) dipped as the Average Workweek slipped.  THW so far in Q223 are flat relative to the Q123 average, pointing to modest GDP growth this quarter.   The Atlanta Fed model's latest estimate is 2.0%.  When combined with the 1.3% GDP growth in Q123,  economic growth may be below trend in H123.  Indeed, the 0.3% point jump in the Unemployment Rate to 3.7% could be catch-up to this slow pace.  It is clearly in the right direction for the Fed.  Moreover, the 0.3% m/m increase in Average Hourly Earnings, after a downward-revised 0.4% in April (was 0.5%), equals the prior 3-month average and shows a further containment of labor cost inflation so far this quarter -- perhaps a result of the easing in labor market conditions.  The annualized m/m increase is roughly in line with the 3.0% trend in Compensation/Hour.

There is a possibility of a slowdown in the May CPI, due June 13.  It would require flattish Used Car Prices and Airfares, as well as declines in some areas.  At this point, a 0.1-0.2% m/m Total CPI and 0.3-0.4% Core can't be ruled out.  Both rose 0.4% in April.

    

Stock Market And The FOMC Meeting

The stock market may pull back over the next couple of weeks now that a debt ceiling deal has been announced-- on some profit-taking or caution ahead of the June 13-14 FOMC Meeting.  If so, there is reason to think the market will resume its rally after the Meeting, regardless of the outcome.

There are three possible outcomes to the Meeting -- /1/ a 25 BP hike, /2/ No hike, and /3/ No hike but said to be just a pause in the tightening path. 

 /1/ With recent US economic data pointing to continued growth, and this week's key data risking the same, a 25 BP hike may very well be likely.  But, it could have little impact on the stock market, being viewed as not large enough to significantly damage the economy.  In other words, the economy's momentum could be seen as withstanding modestly higher short-term interest rates. 

 /2/ If the Fed decides not to hike, perhaps to avoid hurting the banking sector or counting on credit tightening to slow the economy, the market should rally.  Such a decision would be pro-growth.  Note that an Atlanta Fed survey suggests credit tightening is having little effect on businesses.  In contrast, Mortgage Applications might be beginning to be impacted by tighter lending standards.

/3/ A pause but with a promise to resume hiking if needed should be a positive for the market, as the immediate danger is pushed ahead.

Claims for Unemployment Insurance undermine the idea of a worsening economy.  Initial Claims have moved down toward the lower end of the range seen since February, suggesting the pace of layoffs has slowed.  And, Continuing Claims have turned down, suggesting hiring has picked up.  The Claims data highlight the risk of another speedup in May Payrolls -- contrary to the consensus estimate of a slowdown.

The consensus estimates of this week's key US economic data encourage the idea of a pause in Fed tightening.  The May Employment Report is expected to show Payrolls slowing to +195k from +253k in April, the Unemployment Rate edging up to 3.5% from 3.4%, and Average Hourly Earnings slowing to +0.3% m/m from +0.5%.  These are all still too strong for the Fed, but their m/m moves are in the right direction.  Consensus also looks for a dip in the June Mfg ISM to 47.0 from 47.1.  Some evidence -- Markit US PMI and lagged Phil Fed Mfg Index -- supports the idea of a decline.  

A decline in Job Openings in the April JOLTS Data would lend support for a pause, as the Fed views the figure as a measure of excess demand for labor.  A decline is far from certain, however.  The question is whether the jump in April Payrolls filled the openings, pushing the latter down.  Or, did the Payroll jump signify a ratcheting up in demand for labor, which could show up in an increase in Job Openings, as well.   

Recent data point to some divergences among the Q223 GDP components, but on balance add up to moderate growth according to the Atlanta Fed model (1.9% is the latest estimate) -- perhaps enough to handle modestly more Fed tightening.  Consumption looks to be moving up, Residential Construction may be flattening out if not turning up, and government purchases (particularly for defense) are strong.  In contrast, net exports and inventory investment have turned down.  This week's report on April Construction Spending will provide more evidence regarding Residential Construction and also business-related construction activity.  The repatriation of manufacturing operations already is showing up in increased construction activity in this sector.  Construction of alternative energy infrastructure and EV-related factories also could provide a boost.

 

 

Policy Pause Coming?

With the debt ceiling crisis possibly close to resolution, the stock market may turn cautious as it focuses on the likelihood of a pause in Fed tightening at the June 13-14 FOMC Meeting.  Fed officials made somewhat conflicting comments regarding a pause last week.  Some Fed Bank Presidents said that recent US economic data were not weak enough to justify a pause.  In contrast, Fed Chair Powell said that rates may not have to be lifted as much as the markets anticipated because of tighter credit conditions stemming from the banking crisis. The decision at the June FOMC Meeting may depend on /1/ upcoming evidence of weak economic activity or low underlying inflation, or /2/ evidence of a sharp tightening in bank lending.

The Fed Presidents are right that the latest data have not been weak.  The most important data last week were the declines in Initial and Continuing Unemployment Benefits Claims.  They reversed the prior week's jumps and brought them back to levels in line with those seen since March.  They do not show a significant worsening labor market in May.  The 4-week average of Initial is 244k, not much different from the 240k going into the April Payroll Survey Week.  Continuing are below the level in the April Survey Week.  We need one more week of Continuing Claims data to complete the picture of the labor market moving into the May Employment Survey Week.  As they stand now, the data raise the risk of another speedup in May Payrolls.

Although a worsening labor market hurts many people, it may be necessary to bring down wage inflation.  What's putting upward pressure on wage inflation may be a too-high level of economic activity.  The level has to fall.  There are two ways to lower the level of activity relative to long-run trend: /1/ recession or /2/ an extended period of below-trend economic growth.  The latter takes time (perhaps more than the typical year-long length of recession).  And, the downside is that high inflation could become entrenched during this period.  Moreover, slow growth would be as painful as recession for some people.  So, the Fed may decide that further aggressive policy tightening with a consequential recession is preferable to a pause in tightening.

One development that could change this decision is a sharp slowdown in price inflation.   The flattening in commodity prices is helpful, but they represent a small share of production costs.  A sharp slowdown in housing rent could help significantly.  Ironically, Fed tightening could be working against   this possibility.  Higher interest rates reduce demand for home ownership, pushing more people into the rental market.  They also make it costlier for builders to construct new homes, thus limiting supply.  Housing Starts have been in the 1.4-1.5 Mn range (annualized), which is below the estimated 1.62 Mn pace needed to meet annual demand.

  

 

 

 

 

Three Areas of Concern for Stocks

The stock market has three areas of concern over the next few weeks:  /1/ action on the debt ceiling,  /2/ extent of economic weakness, and /3/ whether the Fed will pause at the June FOMC Meeting.  These concerns could keep the market in a range.

The debt ceiling has to be raised by the start of June, either for a short or long period of time.  Although the Democrats and Republicans have not budged from their stated positions, the postponement of Friday's meeting of the two leaderships could be a good sign according to news sources.  The two staffs are working behind the scenes to hammer out a solution, and the delay suggests they're still at it.  Presumably, we will know whether they were successful at some point this week.

There are four US economic releases this week that bear on the question of slowdown or recession -- April Retail Sales, April Manufacturing Output (part of Industrial Production), April Housing Starts/Permits and Unemployment Benefit Claims.  Consensus estimates for the first three are more consistent with sluggish growth than recession.  

Consensus looks for Retail Sales to rebound in April after falling in March.  Total is seen +0.7% m/m after -0.6%, while Ex Auto is seen +0.4% after -0.4%.  Revisions to February and March will play a role in determining how April stands relative to Q123.  As currently printed, consensus estimates would put the April level essentially flat relative to the Q123 average.   Note that while the market did not like the drop in the University of Michigan Consumer Sentiment Index for mid May, released on Friday, the Index is not a reliable predictor of Retail Sales.

Consensus expects April Manufacturing Output to edge up 0.1% m/m, after falling 0.5% in March.  The risk is that it could print slightly higher.  Just like for Retail Sales, the consensus estimate would put the level of April Manufacturing Output about equal to the Q123 average.

Consensus sees a small decline in April Housing Starts and flat Permits.  Both levels would be essentially equal to the Q123 average.  What will be important is whether 1-Family Starts/Permits continue to climb, having done so in February and March.  They have a larger and more immediate impact on construction activity than do Multi-Family Units.  

This week's most important release is Unemployment Claims.  They are the broadest measure of economic activity among high-frequency data.  And, it will be important to see if last week's reported jump in Initial Claims carries over to a jump in Continuing Claims in this week's data.  A jump in Continuing will suggest that hiring did not offset the surge in layoffs.  And, if this situation worsens even more over the next couple of weeks, the Claims data would point to a slowdown in May Payrolls and a higher Unemployment Rate.  The Fed may need to see evidence of a weakening labor market to decide whether to pause in tightening.

The latest inflation data were not soft enough to guarantee a pause in Fed tightening, but they didn't close the door either.  /1/ The 0.4% m/m April CPI (Total and Core) is double what the Fed wants.  To be sure, the picture would look a lot better without Owners' Equivalent Rent (OER) and Used Car Prices.  Excluding them, Core CPI rose only 0.2%.  The jump in Used Car Prices could be temporary, as their wholesale prices have begun to decline again.  OER would seem to have room to catch up further to the weakness seen in private surveys of housing rent.  If OER does not slow to 0.2%, then other components of the CPI would have to weaken further to get to the Fed's target.  /2/ The increase in 5-Year Inflation Expectations to 3.2% in the Mid-May Michigan Sentiment Survey is not what the Fed wants to see.  The print is above the 2.8-3.0% recent range, raising the possibility that long-run inflation expectations are becoming unhinged.  The Fed's hawkish rhetoric is not likely to change, even if it pauses in tightening.

 

 

A Good CPI This Week?

The stock market survived last week's unfriendly events -- only a tentative hint of a pause in tightening by the Fed, stronger-than-expected April Employment Report, and renewed fears of bank problems -- as it was helped in part by stronger-than-expected corporate earnings releases.  Corporate earnings could be important this week, as well.  And,  help from a lower-than-consensus April CPI this week can't be ruled out.

Consensus looks for a still-high 0.4% m/m for both Total and Core April CPI.  A consensus print is more than possible.  But, a below-consensus print can't be ruled out.  To be sure, Total should rise by more than March's +0.1% as a result of higher gasoline prices.  But, food and utility gas prices should be soft again.  A below-consensus Core will likely require another low print for Owners' Equivalent Rent, a slowdown in Airfares and Hotel Prices, and flattish Used Car Prices.  A soft April CPI would encourage the market to expect a pause in Fed tightening at the June FOMC Meeting.

The April Employment Report, however, was too strong from the Fed's perspective.  Even taking account of the large downward revision to March, the 2-month average exceeds the pace needed to keep jobs in line with population growth (209k versus 100k).  The low 3.4% Unemployment Rate confirms a very tight labor market.  And, the 0.5% m/m increase in Average Hourly Earnings warns of the inflationary consequences of the latter.

If the +253k m/m April Payroll jump were just catch-up after the +165k March increase, then Payrolls should slow sharply in May.  But, so far, the Claims data don't support this possibility.  In particular, if Continuing Claims stay at their latest level, they would be below the level in the April Payroll Survey Week -- pointing to another speedup in job growth.  This relationship correctly predicted the speedup in April.  There are still several more weeks of Claims data to see before a complete picture is available.  Note that the May Employment Report will be released before the June FOMC Meeting.  So, while a below-consensus April CPI should encourage the idea of a pause in Fed tightening, the question of whether this will happen in June will remain.