A Somewhat Disappointing Fed?

Strong corporate earnings reports may help the stock market get through a somewhat disappointing FOMC Meeting this week.  The Fed is not expected to cut rates and the Statement will not likely change from December's -- continuing to say that "inflation remains somewhat elevated" and "the downside risks to employment rose in recent months."  However, Powell may present a more balanced view of the risks in his news conference than he has in the past few meetings. 

Powell may feel less compelled to lean toward a Trump-desired policy easing because of the threat to Fed independence stemming from the DoJ's investigation into his Congressional testimony.  Even without this political interference, the US economy appears to be doing well and not needing further monetary policy stimulus.  Evidence to this effect is seen on both the real and inflation side of the economy.  Nonetheless, a Fed ready to ease if needed should be seen as providing positive support for stocks in the background.

The Atlanta Fed Model now predicts 5.4% for Q4 Real GDP Growth, which would be the third strong quarter in a row.  Good-sized gains in October and November Consumption support the model's prediction for Q425 Real Consumption.   Some of the model's predictions of other components of GDP are questionable, however.  So, the model's prediction should be viewed with caution at this point. 

Importantly from the Fed's perspective, the economy's strength may be finally helping the labor market, seen by the ratcheting down in Initial and Continuing Claims in January.  Although a little early, the Claims data suggest a speedup in January Payrolls from December's +50k m/m pace.  Nevertheless, it would be premature for the Fed to change the Statement regarding the labor market at this point -- although Powell may mention the improvement in Claims (thereby damping the downside employment risk in the Statement).

The economy's strength may be a factor in the steady inflation rate seen over most of last year.  The Total PCE Deflator rose by 0.2% m/m in 5 of 8 months since April 2025.  The Core PCE Deflator rose 0.2% in 7 of the past 8 months.  Both rose 0.2% in December.  Their 2.7-2.8% y/y, the longer-term measure Powell likes to refer to, remains above the Fed's 2.0% target.  The shorter-term 3-month annualized increase also is somewhat above target, with Total at 2.5% and Core at 2.3%.

The next couple of CPI reports will be important to see the size of start-of-year price hikes.  Companies could use them as an opportunity to more fully pass through the tariffs.  However, there could have been measurement problems behind some of the large price hikes seen in the December CPI, stemming from the government-shutdown-resulting delays in sampling.  The affected components could settle down in January or February, which month depending on whether bi-monthly sampling is used.  If it is used, then the price jumps in the December CPI could show up in the January CPI to some extent.

All this evidence argues for the Fed to take as wait and see approach to monetary policy.  Whether the tariffs' boost to prices turns out to be one-off should be evident by the Spring.  And, whether AI results in widespread job losses could show up by then, as well.  The window for a Fed easing may open up in a few months depending on how these developments turn out. 

 

 

Supreme Court Hurdles

The stock market may have to contend with important Supreme Court rulings on the Fed and tariffs this week.   On Tuesday, the Court may release its decision on whether Trump can fire Fed Governor Lisa Cook and whether Trump's tariffs are legal.  Possible market reactions are discussed below.  Favorable corporate earnings reports should cushion any market-unfavorable ruling.  

The stock market's reaction to a Court decision could depend on how the latter impacts longer-term Treasury yields.   A decision permitting Trump to fire Cook could be viewed as a step towards undermining Fed independence.  This would exacerbate future inflation risks, resulting in a steeper yield curve --which would be a negative for stocks.  To be sure, a replacement for Cook, along with a new Fed Chairman in May, would lift the probability of Fed rate cuts this Spring.   However, this possibility is likely too far ahead to provide a noticeable boost to stocks now.

In contrast, a Court ruling against Trump's authority to fire Cook could bolster the idea of Fed independence.  The yield curve should flatten, which would be a positive for stocks.  A decision that does not address Trump's authority to fire a Fed Governor but allows Cook to keep her job may have a minor impact on the stock market.  The question of Fed independence would just remain in the background and be ignored for now.  Such decision, however, could dampen the probability of a rate cut this Spring, making it more dependent on upcoming US economic data.

A Court decision permitting Trump's tariffs could be a positive for the stock market.  It would retain the government's collection of tariffs that have helped reduce the Federal Deficit, which is a positive for longer-term Treasuries and thus stocks.  The inflation boost from tariffs may be mostly behind us, so it could be a less important implication for the markets.  However, since it would leave open the door for Trump to impose more tariffs by whim, it would maintain a degree of uncertainty in the economic outlook that could hurt growth.  This impact would remain to be seen, so should not have an immediate effect on stocks.

A decision against Trump's tariffs could lift longer-term Treasury yields, a negative for stocks, because it would lift estimates of the Federal Budget Deficit.  However, since Trump has said there are other ways to maintain tariffs besides his declaration of a state of emergency, the markets' reaction may be muted.

Meanwhile, the macroeconomic background appears to be shifting against the need for a Fed rate cut.  Although the headline December CPI was benign, with Total +0.3% m/m and Core +0.2%, the composition did not show widespread softness.  There were a number of large increases, possibly related to tariffs or to lingering issues from the government shutdown's interference with the CPI survey.  The Fed will likely wait to see a sustained broader pattern of modest inflation before saying inflation is "licked."

The real-side of the economy appears to be doing well.  The Atlanta Fed Model's latest estimate of Q425 Real GDP Growth is 5.3% (q/q, saar) -- implying another quarter of strong productivity growth.  Manufacturing Output in the Industrial Production Report has picked up over the past two months from a flattish span in the prior three months.  And, the labor market may have begun to improve, seen in the downward trend of Unemployment Claims over the past three or four weeks.  

 

Strong Corporate Earnings Season Begins, CPI on Docket

The stock market may continue to rally this week, as expected strong corporate earnings reports begin to be released  However, there could be some caution going into Tuesday's release of the important December CPI.  The consensus estimate is not soft enough to back a Fed rate cut at the January 27-28 FOMC Meeting.  A below-consensus print for the Core CPI cannot be ruled out, nonetheless.

Consensus looks for +0.3% m/m for both Total and Core CPI for December.  The y/y would be steady at 2.7% for Total and move up to 2.7% from 2.6% for Core.  Both the m/m and y/y would not show any movement toward the Fed's 2% inflation target -- arguing against a January Fed rate cut.  

There are mixed considerations regarding whether the Core CPI prints 0.2% or 0.3%.  There is a decent chance that the Total CPI will print 0.2% even if the Core rises 0.3%.  

Supporting the consensus 0.3% estimate, tariffs could continue to lift some prices.  And, Airfares could rise thanks to seasonal factors.  They add to Airfares in December after subtracting in October and November.  Owners' Equivalent Rent could be a problem, as mentioned below.   

Lower-than-consensus CPI prints are possible, however, but likely require Owners' Equivalent Rent (OER) to stay low at 0.1% m/m and Airfares and Lodging Away From Home to be little changed.  /1/ OER appeared to have been estimated at 0.1% for both October and November by the Bureau of Labor Statistics (BLS).  It fits with private surveys indicating a slowdown in rents.  However, if the December survey shows the BLS estimates were too low, the entire correction could be put into the December OER, causing the latter to jump.  /2/ Seasonal factors boost Lodging by less in December than in November, suggesting a slowdown in the Lodging component of the CPI.   

The other important US economic data this week will be December Retail Sales.  Consensus looks for good-sized increases of 0.4% m/m for both Total and Ex Auto.  The latter would match the November gain.  A consensus-like print would show that the weak labor market is not severely hurting consumer spending.  A boost to consumers' wealth from stock market gains could be the offsetting factor fueling consumption.  Solid consumption growth is embodied in the Atlanta Fed Model's latest (but early) estimate of a very strong 5.1% increase in Q425 Real GDP Growth.  As it stands, the latter points to another quarter of strong Productivity Growth --  a positive for corporate earnings and the Fed's inflation fight.

The December Employment Report confirmed a soft labor market but apparently not soft enough to dampen wage inflation.  Besides a small 50k m/m increase in Payrolls, the Nonfarm Workweek fell back to 34.2 Hours from 34.3 Hours in November.  Both figures show that companies are holding back on using workers, possibly substituting AI for them.  Although the Unemployment Rate slipped to 4.4%, it remains high.  

Despite the soft labor market, Average Hourly Earnings (AHE) stayed at 0.3% m/m, the average pace in 2025.   The y/y rose to 3.8% from 3.6%.  There was better news on labor cost inflation in the Q325 Productivity Report.  Compensation/Hour -- the broadest measure of labor costs -- rose a below-trend pace for the second quarter in a row.  The y/y at 3.2% is roughly in line with AHE.  Both are consistent with the Fed's 2% inflation target once productivity is taken into account.  This is seen in the 1.2% y/y for Q325 Unit Labor Costs.  Labor costs are not the culprit behind cost pressures on prices.  The culprit is tariffs, seen in the surge in Non-Labor Unit Costs in Q225 and Q325 (7.8% and 11.6%, q/q saar, respectively).

 

 

 

 

 

This Week's Key US Economic Data

The stock market may be boosted initially by the successful US action in Venezuela, but then turn cautious as this week's key US economic data may not be weak enough to push the Fed to ease at the end of the month.  A more likely window for a Fed rate cut is in the Spring (see my December 14 blog).  Nevertheless, expectations of strong Q425 corporate earnings should restrain any pullback.

The December Employment Report is expected to show Payrolls and Unemployment in the same range that had prompted the Fed to cut rates last year.   However, with a number of Fed officials saying the Fed already has eased a lot and further progress against inflation is needed to justify additional rate cuts, a more significant weakening in the labor market may be needed to sway them to a dovish position.

Consensus looks for a modest +55k m/m increase in December Nonfarm Payrolls (+50k Private Payrolls), which is a smaller increase than the +64k in November (+69k Private) and the +78k m/m prior 12-month average.  However,  the risk is for a larger increase than November's,  based on Continuing Claims (see table below).  The bi-weekly ADP Private Payroll Estimate also points to a speedup in Private Payrolls, and consensus looks for the monthly ADP Estimate to show a 50k increase after -32k in November.  While both Continuing and ADP give the same signal for December, Continuing remained a more consistent predictor of speedups/slowdowns in Private Payrolls in November.  Keep in mind that the Fed thinks the monthly change in Payrolls is overstated by 60k, so they would consider a near-consensus print to indicate a decline in Payrolls.

The improvement in Continuing Claims in December also suggests that consensus is right in looking for a dip in the Unemployment Rate to 4.5% from 4.6% in November.  Rounding analysis also keeps open the possibility of a dip.  The unrounded Unemployment Rate was 4.56% in November, so it doesn't take much to round down to 4.5% in December.  

Consensus also expects Average Hourly Earnings to return to a trend 0.3% m/m in December.  The y/y would edge up to 3.6% from 3.5% with this m/m change.  This could be the most important part of the Report, particularly if AHE slows to 0.2% or less.

This week's delayed release of the Q325 Productivity Report will provide a broader measure of labor costs.  Consensus looks for Nonfarm Productivity to rise 3.0% (q/q, saar), versus 3.3% in Q225.  Both are well above the 2.1% trend in 2024, albeit that the Q225 pace was just a rebound from a decline in Q125.  The Fed will like a strong Productivity print (and the risk is for a larger increase than the consensus estimate) as a way to prevent labor costs from being inflationary.  This is seen in Unit Labor Costs, which are expected to climb only 1.0%.  A 4.0% rise in Compensation/Hour -- the broadest measure of labor costs -- falls out of the calculations.  This is in line with the 4.0% y/y pace in Q225 and 4.4% y/y pace in Q424.  So, it would indicate steady nominal wage inflation.   Note that the Fed will likely wait to see if the large productivity gains continue before raising its estimate of longer-run non-inflationary growth significantly.

This week's other data are expected to be little changed from the prior month or trend.  The December Mfg ISM is seen up slightly to 48.3 from 48.2 in November.  The JOLTS Data are expected to show Job Openings edging up to 7.73 Mn in November from 7.67 Mn in October.

                                       Private Payrolls (m/m change, 000s)   

                        ADP Estimate        First-Print BLS        Latest-Print BLS    Continuing Claims *        

    March               155                          209                            120

    April                   62                          167                            133                               14                            

    May                    37                          140                              69                              -74           

    Jun                    -33                            74                             -27                              -57                              

    Jul                    104                            83                               77                               18   

   Aug                     54                            38                               -4                                 2                            

   Sep                    -32                           119                              104                             28 

   Oct                     42                             na                                52                             -41 

   Nov                   -32                            69                                na                               14

    Dec                   41                            na                                 na                               30     

 * the inverted change in Continuing Claims between Payroll Survey Weeks, 000s                                                                  

 

Strong Corporate Earnings and Productivity Growth

The stock market should be supported this week by expectations of another strong quarter of corporate earnings to be reported in January.  Although the next FOMC Meeting is not until the end of January, market "talk" also may center on the implications of strong productivity growth for monetary policy after last week's release of Q325 Real GDP.  If strong productivity is sustained, it would point to strong growth with low inflation.   It means that the Fed could still cut rates while GDP Growth is strong.

Productivity has been growing well above the trend seen in earlier years.   The typical estimate of trend productivity in the 1990s and early 2000s was 1.0-1.5%.  In 2024, the official measure of productivity rose 2.1% (Q4/Q4).  In H125, productivity averaged 0.8%, but this weakening may be temporary.  Using the difference between Real GDP Growth and Total Hours Worked (THW) as a proxy for productivity suggests strong productivity growth in H225.   The proxy suggests the Q4/Q4 growth will be close to 2.0% -- similar to that of 2024 (see first table below).   Note that this proxy has underestimated official productivity figures more often than not in recent quarters. 

Higher trend in productivity growth means that faster GDP Growth need not put pressure on the labor market.  The non-inflationary trend in GDP Growth would have moved up.  With trend labor force growing about 1.0% per year (based on population growth), trend GDP Growth (sum of labor force and productivity growth rates) is likely around 3.0% rather than the 1.8-2.0% Fed estimate of longer-term growth.  This pace should be consistent with both steady unemployment and inflation, if labor force participation rate is steady.  The participation rate, however, has risen since July.  If this is the start of an uptrend, labor force growth should continue to grow faster than the trend based on population growth alone and lift the Unemployment Rate further.  It would allow economic growth to exceed 3.0% without stirring up inflation.

This combination would argue for the Fed to refrain from tightening while GDP Growth looks to be excessive from an historical perspective.  Indeed, if AI is behind the ratcheting up of productivity growth and is resulting in fewer people being hired, the Fed should aim for even faster GDP than the higher trend growth rate.  

To be sure, it is difficult to predict the trend in productivity or labor force participation ahead.  The Fed has to judge whether sustained 3-4% Real GDP Growth will lead to higher inflation.  How the Fed responds could depend on whether the economy is operating at full employment.  At full employment, the risk is that the faster growth would result in higher inflation .  Higher interest rates would be required to match the productivity-driven higher rate of returns on business investments.  Otherwise,  investments would accelerate and consumption be boosted by a stronger stock market, both possibly leading the economy into inflationary territory.  At less than full employment, the Fed could allow more time to assess the possibility of sustained higher productivity (and labor force growth), keeping interest rates low and allowing the economy to grow faster than its earlier trend.  Currently, the high 4.6% Unemployment Rate means that the fast GDP pace in Q325 and expected for Q425 should not stop the Fed from maintaining an accommodative monetary policy.

Besides an accommodating Fed, the productivity-driven faster GDP Growth is a positive for corporate profits.  Consensus looks for about 8% y/y for S&P 500 earnings in Q425.  Although this is below the near-15% gain seen in  Q325, the risk is that the consensus estimate is too low.

The macroeconomic evidence supports strong corporate earnings in Q425.  Real GDP Growth looks to be up sharply on a y/y basis in Q425 (see second table below).  And the weaker dollar combined with better economic activity outside the US means that earnings from abroad should boost US company profits, as well.  These pieces of evidence are stronger in Q425 than in Q325.  Although profit margins may have been held down in Q425, as core inflation rose by less than wages, they could have been offset by the depressed pace of Payrolls -- holding down the "wage bill."  

                                                       Annualized Growth Rate                  

                            Real GDP Growth Less THW                Official Productivity Growth

Q124                                0.5                                                            1.7

Q224                                2.8                                                            2.9

Q324                                3.0                                                            2.1

Q424                                0.4                                                            1.6  

Q4/Q4                             1.7                                                             2.1    

Q125                                -1.3                                                         -1.8 

Q225                                2.3                                                            3.3

Q325                                4.3                                                            na

Q425    *                          1.7                                                            na   

Q4/Q4                              1.8                                                            na 

* Using Atlanta Fed Model's early estimate of 3.0% (q/q, saar), for Q425 Real GDP Growth and November' THW to represent Q425 average.  

                                                                                                                                          Eurozone                        Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    Mfg PMI  

          [                                y/y percent change                                                   ]          (level)

 Q124            2.9                +14.0                  0.0                              4.3           3.8              46.4 

Q224            3.0                  +2.5                +3.0                              3.9           3.4               46.3 

 

Q324            2.7                  -6.0                 +2.5                              3.8           3.2               45.3     

 

Q424            2.5                   0.0                 +3.5                              4.1           3.4               45.4       

 

Q125            2.1                  -6.5                +6.0                               3.9           3.1               47.6                                       

Q225            2.0                -16.0                +3.5                               3.9           2.8               49.3     

 

Q325            2.3                -11.0                -1.5                                3.8           3.1               50.0  

 

Q425            2.6  *            -14.0                -4.0                                3.5           2.6               53.3                                                                                        

                                                                           

* Based on the Atlanta Fed Model's latest projection of 3.0% for Q425 (q/q, saar).

 

 

Year-End Rally?

The stock market may try to eke out a year-end Christmas rally in the next couple of weeks, as the macroeconomic background is not standing in the way.  Although some Fed officials and market analysts voiced concern about the accuracy of last week's key US economic data,  the latter do not shut the door on a January Fed rate cut even if somewhat distorted.  

The November Employment Report painted a picture of a sluggish labor market.  Private Payrolls sped up to only 69k m/m from +52k in October.  The latest 3-month average is 75k m/m, which may in fact be only +15k if the Fed is right that the m/m changes in Payrolls are now overstated by 60k.  With job growth so slow, it's not surprising that the Unemployment Rate has moved up noticeably.  These two parts of the Report confirm the Fed's concern of a weak labor market.  

That said, other parts of the Report argue against a weakening economy.  Although companies held back in expanding payrolls, they lengthened the hours worked by existing employees.  The Nonfarm Workweek edged up to 34.3 Hours from a low 34.2 Hour in the prior two months.  As a result, Total Hours Worked (THW)  in November are about 1.0% (annualized) above the Q325 average (taking account of the overstatement in Payrolls), compared to 0.0% (q/q, annualized) in Q225.  The improvement in THW so far in Q425 suggests a speedup in economic growth.  However, all that may be happening is a catch-up in this measure of labor to the strong GDP Growth in Q325 -- if the Atlanta  Fed Model's 3.5% estimate or the consensus estimate of 3.2% of the latter is correct (the actual will be released on Tuesday).  

A more interesting possibility is that AI and other capital investments are substituting for labor without hurting GDP Growth.  While some growth in THW through a longer workweek is needed to meet demand, Productivity Growth has ratcheted up.  If this is correct and sustaining, then the longer-run, non-inflationary trend in economic growth is significantly higher than the 1.8-2.0% Fed estimate.  In this case, the Fed should aim for stronger Real GDP Growth than what it has been doing.   It would call for easier monetary policy next year.  From a stock market perspective, it would be a positive for corporate earnings even if the Fed does not cut rates.

The low November CPI, at least on the surface, offered hope that inflation is moving down.  The y/y fell to 2.7% for Total and 2.6% for Core.  Some Fed officials and market economists raised questions about the ways some major components, such as Owners' Equivalent Rent (OER), were calculated, given the timing and sampling issues stemming from the government shutdown.   OER was estimated to rise by the same percentage change in October and November as the low print for September.  This may not be a bad estimate, however, despite the doubt expressed by some.  A sustained low rate of increase in OER would be consistent with the softening in rents seen by private surveys.  The accuracy issue with the CPI could be resolved with the back-to-normal December CPI Report, which should be released before the January FOMC Meeting.

 

 

 

When Is The Next Fed Rate Cut?

The stock market is now focused on whether and when the Fed will ease next year.  Although this week's key US economic data -- November Employment Report and CPI -- may shed light on the answers to these questions, they will probably not be conclusive since the Fed believes they could be subject to measurement problems related to the government shutdown.  A better sense for the answers may be inferred from Fed Chair Powell's comments at his post-FOMC news conference last week.  They suggest the most likely window for another rate cut is from the Spring on.  

Powell provided guidelines on how the Fed thinks the economic background will unfold in 2026.  The Central Tendency Forecast for Real GDP Growth was raised to 2.1-2.5% (Q4/Q4), putting it above the longer-run estimate of 1.8-2.0%.   He said that 0.2% pt of the 2026 growth results from a bounce-back from the government shutdown, which had subtracted a like amount from 2025 GDP growth.  Most of this bounce-back should be seen in Q126 -- adding 0.8% pt to the annualized q/q growth rate then.   A resilient consumer and strong business investment, in part due to AI, are also behind the GDP speedup.   The $2,000 tariff-offset tax refund should help the consumer in H126, as well.

Regarding inflation, Powell says the Fed's best guess is that the impact of tariffs will be a one-time boost to the price level, so that the impact on inflation will be short-lived.  He expects most of the boost will occur by Q126, then flatten out in the Spring and disappear in H226.  A goal of the Fed is to prevent this one-time boost from precipitating a sustained speedup in inflation, in other words a wage-price spiral.  He mentioned that the slowdown in the Q325 Employment Cost Index was a good sign that wage inflation remains in check.  And, he reiterated that the tariff-impacted goods prices are the main reason for this year's pickup in inflation, as services inflation has been soft.

If the Fed is right that economic growth and inflation may be highest in Q126, then the window for a Fed rate cut will become more of a possibility in the Spring and in the second half of the year.  Nonetheless, Powell did say that the upcoming slew of US economic data will be important considerations at the January FOMC Meeting.  However, he pointed out they could be distorted by technical problems.  So, the Fed may be reluctant to rely on them to make a policy decision.

In particular, the CPI and Unemployment Rate could be mi-measured because of deviations from the standard timing of their surveys in October and November.  Besides a question of full survey information, the timing could be out of sync with seasonal adjustment.  And, the m/m change in Nonfarm Payrolls will be overstated by about 60k (as they have been in recent months) because of a persistent problem in the way jobs are estimated for the net change in new and closed businesses.  

Powell also mentioned the importance of the Unemployment Claims data, highlighting that the recent decline in Initial Claims had suggested fewer layoffs while the still high Continuing hinted at more cautious hiring.  December-January Claims data, however, are tricky to seasonally adjust because of the varied timing of holidays from year to  year.  The sharp swings in Initial and Continuing in last week's report are illustrative.  So, the Claims data may not be reliable measures of the labor market at this time, making it more difficult for the Fed to figure out what's happening.  

This week should see the Employment Report and CPI for both October and November.  Given the Fed's estimate of a 60k overstatement of the m/m change in Payrolls,  the chances are that both month's figures will be viewed as weak by the market.  Payrolls averaged 62k m/m (2k after subtracting 60k per month) during Q325.  The m/m change in the Unemployment Rate could confirm or raise doubt about the weak jobs figures.  Continuing Unemployment Insurance Claims suggest the Unemployment Rate has risen since September.  The sampling issue Powell alluded to, however, suggests it should be viewed with caution.

The October-November CPI also may be impacted by sampling problems, according to Powell.  Market-friendly prints would be 0.2% m/m or less, with the Core more important than Total.  Such a low print would be below the 0.3% m/m increase implicit in the Fed's Central Tendency Forecast for the Q4/Q4 inflation rate.  A low print can't be ruled out.  Owners' Equivalent Rent would need to be soft, as in September, and Airfares and Lodging Away From Home need to rise at most modestly.  Seasonals help to hold down Airfares in these two months, but they boost Lodging Away From Home.