Fed Policy Shift?

The stock market may remain under pressure this week, as prospects of a Fed rate cut in December fade amidst typical year-end tax-related selling.  However, keeping rates steady is not necessarily bad for stocks, although it shifts the counter-cyclical burden to the markets.

Fed Chair Powell and other Fed officials continue to hint that rates will be held steady at the December  17-18 FOMC meeting.  Powell said "the economy is not sending any signals that we need to be in a hurry to lower rates."  He appears to be finally acknowledging that the economy's recent strength is sustainable, suggesting that the Fed's Central Tendency update at the meeting will show stronger GDP Growth as well as a higher funds rate for next year than in the September Central Tendency forecasts.  

Steady rate Fed policy may not be entirely bad for stocks.  It would preserve room for the rate to be cut when the economy in fact needs it.  This potential to ease represents an insurance policy for stocks regarding the economic outlook, which is a market positive.  

The markets, however, will play a greater role in determining whether financial conditions should be tighter to fight inflation or easier to fight the risk of recession.  The long end of the Treasury market will sell off if inflation and/or the economy look to be speeding up or it will rally if inflation/economic growth appear to be slowing.  The long end's actions could determine the path of the stock market, with stocks moving inversely with the long-end yields.  Handing over counter-cyclical policy to the markets may be the best approach for the Fed in the face of uncertain fiscal policy in 2025.  The markets will move more rapidly in response to events than would Fed monetary policy and be immune to political flak.

Between now and the December FOMC Meeting real-side economic data risk speeding up as they rebound from bad weather and strikes.  The markets may not react sharply to this strength,  however, discounting it as temporary.   What may be more important will be data on wages and prices, as measured by Average Hourly Earnings (AHE) and the CPI.  A slowdown would be a relief for long-term Treasuries and stocks, while a still-high pace could spark a sell-off.  There is no reliable evidence for November AHE.  There is a possibility that the November CPI could move down to 0.2% if the handful of components with large changes in October flatten out and Owners' Equivalent Rent returns to 0.3% from 0.4% in October.

Powell still does not acknowledge an inflation problem.  He downplayed the high October Core CPI and Core PPI, translating them into sub-3.0% y/y increases in the Total and Core PCE Deflators.  Citing y/y increases, however, is disingenuous since they are dominated by past inflation prints.  His figures imply 0.2% m/m for Total and 0.3% for the October Core PCE Deflator, the same as in the CPI.  These would not be good prints, as the Core would be elevated for the second month in a row.  To be sure,  perhaps he just applied the CPI m/m increases to the PCE Deflator, although his figures appeared to be presented as forecasts.  Smaller increases can't be ruled out because components are weighted differently in the PCE Deflator than in the CPI.  The PCE Deflator will be released November 26.

 

  

     

 

"Trumponomics" and the Fed

The stock market rally should continue this week, with possible help from a below-consensus October CPI.  Prospects of a pro-growth Trump economic policy should underpin the market's strength.  However, the policy could create problems down the road, as it generates inflationary pressures.  Indeed, labor cost inflation remains an issue, even though it has not gotten much, if any, mention in the press or by the Fed.

 "Trumponomics" will be an extension of Bidenomics in one way.  It will try to redirect the US economy to being more insular, using tariffs as one tool.  The goal in both overall polices is to bring manufacturing from abroad to the US.  This includes the operations of non-US as well as US companies.  In contrast to Bidenomics, Trumponomics presumably will not direct  investments to particular sectors, e.g., alternative energy EVs.  Instead, it will include tax cuts, deregulation, and presumably increased defense spending (also part of Bidenomics).  In both cases, the associated stimulus help propel US economic growth. 

The problem with both approaches is that the associated stimulus needs to crowd out other domestic spending if inflation is not to speed up, particularly when the economy is operating near full employment as it is now.  Higher inflation is one way the markets crowd out spending.  In the Biden case, the large influx of immigrants -- legal and non-legal -- mitigated the need for crowding out as it boosted the labor force.  This cushion may not exist under Trump, given his threat to stop or reverse the immigration.  As a result, inflation risks could be higher under Trump. 

To be sure, labor cost inflation remains high, even with the influx of immigrants.  Compensation/Hour -- the broadest measure of labor costs -- has sped up on a y/y basis for the second year in a row:  5.5% in Q324 versus 4.8% in Q423 and 2.4% in Q422.  Productivity Growth has been a partial offset, up 2.0% or more (q/q, saar) in each of the past four quarters.  Unit Labor Costs were up 3.4% (y/y) in Q324, versus 2.1% in Q423.  ULC rose 1.9% (q/q, saar) in Q324 (above the 0.5% consensus as was the risk), but they have tended to slow in the second half of the year so they could be understating trend.  They need to stay around 2.0% both on a q/q and y/y basis to be consistent with the Fed's inflation target.

Labor cost inflation along with increased stimulus could lead to a reversal of the Fed's policy easing at some point.  Higher longer-term yields will likely lead the Fed in efforts to restrain demand.  At this point, however, the Fed appears to be steadfast in its policy to lower the funds rate to what it views as a neutral level with regard to the economy.  In his post-FOMC news conference, Fed Chair Powell said that while the Fed is not on a preset course of easing policy, the current policy stance is in a very good place and that the Fed is trying to stay on an easing path that is neither too fast or too slow.  He said the Fed would slow the pace of easing if the rate is closing in on a reasonable estimate of a neutral level.  Fed officials are beginning to think of this possibility, but their baseline forecast is to continue to ease into next year.

Fed Chair Powell made several comments, nonetheless, that raise the possibility of a pause in rate cuts.  He acknowledged that the latest data have reduced the downside risks to the economy.  Some business leaders, he said, think the economy will be better in 2025 than in 2024.  He also acknowledged that wage inflation is currently above the pace consistent with 2% price inflation -- unless productivity remains strong.  However, he said the Fed does not see wages as a significant source of inflationary pressures now.  

Powell blamed housing rent for keeping price inflation above target.  Re-negotiated rent on long-term leases are seen as catching up to more recent rent hikes and that this catch-up will end at some point, suggesting the rent component of the CPI will slow eventually.  There was hope for the latter in the September CPI, where Primary and Owners' Equivalent Rent (OER) slowed to 0.3% m/m from a 0.4% trend.  A repeat 0.3% OER in this week's October CPI Report increases the risk of a below-consensus print.  Consensus looks for +0.2% m/m Total and +0.3% Core.  Moderation in airfares and apparel, both of which jumped in September, are likely needed for a below-consensus print, as well.

Powell made one comment at the news conference that allays concern about Trump's threat to become personally involved in monetary policy decisions.  Powell said he would not resign nor give up the chair of the Fed Board if ordered to do so by Trump.  Apparently, the law prevents Trump from firing or demoting him.  Powell's determination to stay would sustain the independence of the Fed, which is a positive for all the financial markets.

 

Elections and FOMC Meeting This Week

The markets will finally see the results of the US Elections and the November 6-7 FOMC Meeting this week.  They could trade cautiously into these events.  What may be most important for the markets is whether the Presidential Election is resolved without a problem or if neither party dominates all branches of government.  The stock market could have a relief rally in either case.

To be sure, the market impact (stocks, Treasuries and dollar) of the Presidential Election could depend on who wins. But both candidates have policy proposals that are problematic for the economy and markets.  The potential implementation of these proposals could restrain a positive market impact.  Questions will remain whether the proposals will be put into effect, either legislatively or by executive order. 

Some market commentary has attributed the recent sell-off in the long end of the Treasury market to the potential for a blowout Federal Deficit, particularly if Trump is elected.  This explanation, however, may not be entirely right.  If fears of a sharply higher Deficit (and the presumed inflationary result) were the reason, the dollar should have fallen in the FX market, as well.  This did not happen.  Instead, the dollar has strengthened.  An explanation for the combination of higher long-term yields and stronger dollar could be an increasing concern about Trump's proposed tariffs.  The latter would boost the dollar on the expectation of a smaller trade deficit.  The tariffs also would boost inflation initially and thus the long end of the Treasury market through higher inflation expectations.  (Note, that the direct impact of the tariffs on prices should unwind over time as the dollar strengthens.)   If Harris wins, these market moves could unwind --  which would be a positive for the stock market.

The Fed is likely to cut the funds rate by 25 BPs at this week's FOMC Meeting.  And, while Powell should keep open the door for further rate cuts, he may be more cautious about their timing.   The economy appears to be growing moderately, but wage increases may be somewhat problematic.  Total Hours Worked in October are above the Q324 average, despite being held down by bad weather and strikes in the month.  They suggest another quarter of good-sized GDP growth, particularly taking account of a post-hurricane/post-strike bounce-back in economic activity.  The renewed downtrend in Initial Unemployment Claims in the past two weeks also suggests economic growth is fine.  The Atlanta Fed model's early estimate of Q424 Real GDP Growth is 2.3% (q/q, saar).

On the wage front, Average Hourly Earnings (AHE)  rose an above-trend 0.4% m/m in October, the second high print in the past three months.  The y/y rose to 4.0% from 3.9% in September.  The broader Employment Cost Index, in contrast, had better news.  It slowed to 0.8% q/q in Q324 from 0.9% in Q224.  The slowdown fits with the Fed's expectation of a gradual deceleration in inflation.  The ECI averaged 0.6-0.7% before the pandemic.

This week's report on Q324 Productivity/Compensation/Unit Labor Costs, however, risks adding to the labor cost problem.  Consensus looks for Compensation/Hour -- the broadest measure of labor costs -- to rise by only 2.8%, which would be a good number.  But, the risk is for a larger increase.  To be sure, speedier wages would not be inflationary if offset by higher productivity growth.  And, productivity in Q324 stands to be strong.  Consensus looks for 2.3% (q/q, saar) Productivity -- in line with the strong 2.4% average since Q123.  And, the risk is for a higher print.  But, the balance of risks between Compensation and Productivity weighs toward a higher print for Unit Labor Costs (ULC) than the consensus estimate of 0.5%.   The recent trend in ULC has been down, with the y/y hitting a slight 0.3% in Q224, well below the 1.7% y/y increase in Q423.  Anything below 2.0% suggests slower price inflation ahead.

Election Uncertainty, Earnings and Key US Data

Corporate earnings and election uncertainty should continue to dominate the stock market this week.  Although consensus looks for moderate prints for this week's key US economic data, uncertainty about the labor cost measures could dampen the market ahead of the prints.  This week's key data will be the last Fed officials see before the November 6-7 FOMC Meeting.  It is unlikely the data will deter a 25 BP rate cut, but they could influence the Fed's forward guidance at the meeting.

One of the election issues relates to Fed policy.  Trump wants the President involved with FOMC rate decisions.  This relates to Fed independence and, if he wins, would be a negative for the dollar (offsetting in part the positive impact from the threat of tariffs) and lift long-term yields, as the risk would be for political considerations to restrain rate hikes when needed to curb inflation.  

Trump supporters say the Fed makes mistakes and thus needs to be changed.  Ironically, one mistake they accuse the Fed of is representative of what Trump wants.  They accuse the Fed of not tightening soon enough in 2021-22, which they say resulted in higher inflation.  Although Fed Chair Powell attributes the delayed tightening to forecasts of a "transitory"pickup in prices, it would not be surprising if political considerations played a role.  Powell did not want to act in a way that would run counter to Congress' legislative aim to boost the economy.

This is not to say the Fed never makes mistakes.  The Fed did make mistakes in 2007-08, which exacerbated if not triggered the Great Recession.  They made 3 major mistakes:  /1/ They analyzed the problem as an illiquidity issue at banks that required interest rate cuts.  Instead, the problem really was a lack of confidence among banks regarding the extent of subprime mortgage risk in their balance sheets.  A guarantee of bank liabilities for say 5 years by Treasury or the Fed to let them unwind their subprime positions likely would have solved the problem, similar to how the ECB tackled a bank confidence problem in 2011.  Lowering interest rates in 2007-08 boosted commodity prices, particularly oil, which hurt the consumer.  /2/ Fed Chair Bernanke and Treasury Secretary Paulson went on TV to say the US economy was heading into a big recession.  This destroyed business confidence, leading to massive layoffs.  /3/ The Fed did not save Lehman Brothers, punishing the company for its mistakes rather than acting to bolster market confidence (again not understanding the confidence problem).  By the way, this is not the conventional explanation for the Great Recession.

The Fed gets into perception trouble with its Central Tendency forecasts, which are often wrong.  In a sense, the forecasts are bound to fail because markets will move in a way to prevent them from happening.  For example, longer-term Treasury yields could fall if the Fed presents a weak economic forecast.  Lower yields would lift stocks, boosting consumption as well as housing demand.  A better approach could be to publish targets for GDP Growth, Unemployment Rate and Inflation rather than forecasts.  Then, the Fed could be held accountable without seeming clueless about the outlook.

Regarding this week's key US economic data:

Consensus looks for a benign October Employment Report.  Payrolls are seen slowing sharply to +140k m/m from +254k in September, while the Unemployment is seen steady at 4.1%.  Average Hourly Earnings (AHE) are expected to slow to the 0.3% m/m trend, after climbing 0.4-0.5% in the prior two months.  Unemployment Claims data support the idea of slower job growth in October.  In addition, there were 41k additional strikers (including Boeing workers) that will subtract from Payrolls but should be added back to get a clearer picture of the underlying demand for labor.  A 180k Payrolls gain would be somewhat high from the Fed's perspective and be consistent with a lower Unemployment Rate.  Strikers, themselves, do not affect the calculation of the Unemployment Rate, as they are not counted as unemployed.  There is no evidence regarding AHE -- unfortunate since this may be the most important part of the Report.

Regarding labor costs, consensus looks for the Q324 Employment Cost Index to rise 0.9% (q/q), the same as in Q224.  Even though high from a pre-pandemic perspective, a steady pace would be tolerable.  Evidence from AHE is mixed.  AHE sped up in Q324 after slowing in Q224.  In the past 6 quarters, ECI and AHE sped up or slowed together half the time.  The other half the speedup or slowdown in ECI matched that of AHE in the prior quarter, which suggests a slowdown in the Q324 ECI. 

            (q/q percent change)

            AHE            ECI

Q324   1.06              na

Q224   0.87               0.9

Q124   1.02               1.2

Q423   0.97               1.0

Q323    0.92              1.0   

Q223    1.2                1.0    

Q123    1.1                1.2

Q422    1.2                1.1

Q322    1.1                1.2

Consensus looks for 3.0% (q/q, saar) Q324 Real GDP, in line with the Atlanta Fed Model estimate of 3.3%.  A sub-3.0% print cannot be ruled out.  Consensus also looks for the October Core PCE Deflator to rise 0.2% m/m, smaller than the 0.3% increase in the Core CPI and better in line with the Fed's 2% inflation target.  A consensus print for the Core Deflator should be a market positive.

Fed Policy Intentions Helping Stocks

The stock market is likely to continue to grind higher this week, buoyed by the Fed's intention to cut the funds rate further even with above-trend economic growth in Q324.  Indeed, the Atlanta Fed model raised its estimate of Q324 Real GDP Growth to 3.4% from 3.2% (qq, saar) after the strong September Retail Sales report more than offset the implications of the soft Industrial Production and Housing Starts reports. However, the risk of higher wage inflation could become an issue ahead.

The strength of Q324 Real GDP does not appear to have stopped the Fed from planning to cut the funds rate further, albeit at a smaller 25 BP pace from the initial 50 BP cut.  To be sure, the model's estimate may be too high.  Other data show softening in manufacturing output (mostly outside of high tech), housing starts, and Total Hours Worked.  (The official report on Q324 GDP will be released October 30.)  Even if the model's estimate is correct, the Fed's intention appears to be to bring the funds rate down to its longer-term neutral level in order to sustain solid, non-inflationary economic growth -- as long as inflation remains near its 2% target.  The Fed presumably would stop easing if if looks as if the trend in inflation has turned up.

This presumed requirement suggests that the most important part of the October Employment Report could be Average Hourly Earnings (AHE).  It would be problematic if AHE does not fall back to its 0.3% m/m trend after rising 0.4-0.5% in August and September.  Away from the Report, the recent outsized wage gains in the Boeing and Longshoremen contracts are a concern, particularly if it influences other wage demands.  The Payrolls part of the Report should be comforting for the Fed, as the Unemployment Claims data suggest (at this point) a smaller increase than the large +254k gain in September.   The Report is due on November 1.

Fed officials, including Chair Powell, insist that their policy path is data dependent.  Powell says the way to think of data dependency is in terms of the impact on the Fed's outlook.  This approach has two problems, one from the perspective of  the markets and the other from the perspective of the Fed.  The markets' problem is that the impact on the Fed's outlook is not clear.  At the extreme, the Fed's rate decisions could seem arbitrary, with little if any relationship to the data.  The Fed's problem is that its ability to forecast accurately is not particularly good.  Officials could incorrectly dismiss a strong report as one-off, for example -- thus sticking with easing instead of holding back.  They will know whether the dismissal was correct from seeing future data releases, although the more immediate reaction of the longer-end of the Treasury market can offer a hint.  For example, a sell-off in the longer end on a Fed move would hint that the Fed overdid its policy move. 

 

Stocks To Slog Up in Face of Mixed Corporate Earnings and Fed Uncertainty

The stock market will likely slog up over the next few weeks, dealing with mixed corporate earnings reports and uncertainty regarding the Fed rate decision at the November 6-7 FOMC Meeting.  A 25 BP cut is probably the best bet as of now, despite the stronger-than-expected September CPI and Employment Reports.  Expectations of modest prints for this week's US economic data -- Retail Sales, Phil Fed Mfg Index, Industrial Production -- should support this view and help stocks.  However, the most important data for the Fed will likely be the October Employment Report, due November 1.  It is too soon for evidence on Payrolls.

Fed Chair Powell has said that while the intention is to bring the Fed Funds Rate down to a neutral level over time, the pace will depend on the impact of economic data on the Fed's outlook.  The most recent data will not likely derail the Fed's expectation of slower economic growth and lower inflation.

Consensus among market observers is that the September Employment Report and CPI were stronger than the Fed liked.  My view, as discussed in last week's blog, is that the Employment Report was not as strong as appears at first glance.  It is consistent with slower economic activity at the end of Q324 and leaves open the possibility this could continue in Q4.24.  It's unlikely that Fed officials would mention the mitigating parts of the Report in their upcoming speeches, but they should be aware of them.  This week's key US economic data -- September Retail Sales and Industrial Producton --are expected to post slight gains, supporting the idea that growth is moderating.

Although the September CPI showed a wider distribution of speedier increases among components than in recent months, the Fed could discount the speedups as being part of the "bumpy" ride they expect in the decelerating trend in inflation.  Moreover, the one piece of good news in the Report was the sharp slowdown in Owners' Equivalent Rent (OER) to a below-trend 0.3% m/m.  If OER's slower pace persists, the Fed's 2% inflation target may very well be achieved.

Looking ahead to nest year, four possible scenarios are conceivable:  

1.  Aggressive fiscal policy could boost inflation expectations and longer-term Treasury yields -- raising the possibility of renewed Fed tightening.   This would be a negative for stocks.  Both presidential candidates' policies have this potential outcome.

2.  The Fed policy easing in H224 boosts economic growth and inflation in H125, raising longer-term Treasury yields and pulling in expectations of further Fed easing -- a negative for stocks.

3.  Economic growth and inflation continue to moderate, keeping Fed rate cuts on track, positive for stocks.

4.  The US economy somehow slips into recession.  This seems unlikely, unless Fed policy shifts away from easing.

A Strong September Employment Report?

The stock market should climb  this week, after Friday's ostensibly strong September Employment Report dispelled fears of recession.  However, there was less strength than met the eye in the Report.  So, along with benign inflation data expected this week, the Fed should still be on an easing path.  Although Q324 corporate earnings are expected to slow, the slowdown may be temporary.

A large increase in September Payrolls and lower Unemployment Rate were the risk, given the recent decline in Unemployment Claims.  Unless the October Report (to be released prior to the next FOMC Meeting) is as strong, the Fed will not likely stop cutting rates in Q424.  The Fed apparently is focused on its expectation of future weakness stemming from prior tight monetary policy, not current economic activity.  Moreover, although the September Report shows a strong labor market, some parts of the Report suggest the headline Payroll print may overstate strength.  Some of the jobs gain may reflect a shift toward part-time workers.

The Household Survey shows that the number of part-time workers in nonagricultural industries jumped 527k m/m in September, after a string of sub-100k increases in prior months.  To be sure, this should be viewed as only suggestive, given the relatively small sample size of the Household Survey (on which the Unemployment Rate is based) compared to the Establishment Survey (on which Payrolls are based).

A shift toward part-time workers, nonetheless, could explain the dip in the Nonfarm Workweek to 34.2 Hours from 34.3 Hours in August.  But, the dip could be just noise.  It was 34.2 Hours in July, as well, although the industry breakdown was different from that of September.  The dip in Workweek in September did not appear to be mainly among Production Workers.  Their workweek was flat.

Total Hours Worked slipped m/m because of the decline in the overall Workweek.  The Q324 average of THW is only  0.2% (annualized) above the Q224 average, versus +1.6% (q/q, saar) in Q224.   This raises doubt about 2+% Real GDP in Q324.  However, THW may overstate weakness.  This is because THW for Production Workers rose 1.0% (q/q, saar) in Q324, not much below the 1.5% in Q224.  So, Q324 Real GDP Growth still may be in the 2.0% range.  The Atlanta Fed model's latest estimate is 2.5%, but does not yet take account of Friday's data.  The next model update is on Tuesday.

The 0.4% m/m increase in Average Hourly Earnings (AHE) after an upward-revised 0.5% in August is somewhat troubling.  The Q324 average rose 4.0% (q/q, saar), compared to the 3.4% increase by the Q224 average.  The y/y rose to 4.0% from 3.9%.  Nevertheless, large wage gains were not widespread, as fewer than half of the major sectors had large increases.  AHE rose 0.4% m/m or more (on average) in only 6 of 13 sectors in Q324, versus 4 in Q224.

Consensus expects a benign print for the September CPI.  It sees +0.1% m/m for Total and +0.2% for Core.  The risk would be for a higher print if Owners' Equivalent does not fall back to 0.4% m/m after speeding up to 0.5% in August.  Consensus looks for +0.1% m/m Total and +0.2% Core for the September PPI, as well.

Consensus estimates +4.6% (y/y) for Q324 S&P 500 earnings, down from 11.2% in Q224.  The macroeconomic background appears to support a slowdown in earnings.  On a y/y basis, Real GDP Growth slowed, oil prices fell and the dollar strengthened further (thereby making foreign earnings appear lower in dollar terms).  In contrast income from abroad could help profits this quarter.  Based on the European PMI, foreign economic activity improved on a y/y basis, although it slowed q/q.  Profit margins look to have been little changed.  A soft quarter of corporate earnings could be temporary, as consensus, at this point, looks for double-digit y/y returning in Q424 and continuing through 2025.

                                                                                                                                       Markit
                                                                                                                                          Eurozone                        Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    PMI  
                [                                y/y percent change                                                   ]    (level) 

Q123            2.3                -19.5                +3.0                              4.5           5.5               47.9  

Q223            2.8                -32.0                 +0.5                              4.4           5.2               44.7

Q323            3.2                -12.0                 -2.5                               4.3           4.4               43.2

Q423            3.2                -12.0                 -2.5                               4.3           3.9               43.8

 

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            2.6                  -6.0                 +2.5                              3.8           3.3               45.3                                                      

                                                                           

* Based on the Atlanta Fed Model's latest projection of 2.5% (q/q, saar).