Coming to Grips With Powell's Comments

The stock market may continue to be weighed down this week as it comes to grips with Fed Chair Powell's comments.  He was disappointed in seeing three consecutive months of high inflation prints, ignoring the idiosyncratic parts of the March CPI.   As a result, the Fed's inflation target gets higher priority, requiring the need to delay rate cuts.

By also intending to keep the funds rate steady, the Fed appears to be relying on tighter financial market conditions to fight inflation.  Higher yields, weaker stocks, and a stronger dollar are meant to restrain economic activity, thereby holding down inflation.  Consequently, strong data are bad for the markets (implying more restraint is needed), while weak data are good (implying less restraint is needed) from this perspective.  In this regard, Thursday's release of Q124 Real GDP could present a problem.  The Atlanta Fed model's latest estimate is 2.9%, while consensus is 2.1%.  Both are above the Fed's 1.7-2.0% estimate of longer-run growth. 

Whether a weaker economy is needed may depend on whether inflation slows by itself.  A slowdown in the inflation trend would mean the Fed and markets don't have to restrain economic growth.  Steady Fed policy in the context of moderate economic growth and slowing inflation would again be a positive for stocks.

A slowdown in inflation by itself is conceivable.  The industry-specific reasons for the high CPI in March could ease if not reverse somewhat in coming months.  Housing rent could slow as well, as it catches up to the softening seen in private surveys.  Indeed, there is a chance for a surprise low inflation print this week.  Consensus expects a still-high +0.3% m/m in both Total and Core PCE Deflator for March.  The estimate appears reasonable and would not likely be a positive for the market.  But, a 0.2% print for Core can't be ruled out.

There are already tentative signs that the post-winter bounce in economic activity may be easing.  /1/ Initial Unemployment Claims have stopped falling while Continuing turned up a bit.  If they stay at the latest levels, they would suggest a slowdown in April Payrolls.   /2/ The Phil Fed Leading Index of Capital Spending edged down in April.  This should be seen in Durable Goods Orders within the next few months although this week's release for March may be too early.   /3/ Commodity prices possibly may have peaked.  Besides oil, some of the major commodity price indexes are off their recent highs. 

That Powell continues to push back the timing of rate cuts is not surprising.   Economic forecasts, as well as the theoretical idea that real interest rates will rise as inflation expectations fall, are highly tentative and bound to fail when the markets build in future policy.  Higher stocks, lower long-term yields and weaker dollar stemming from projected Fed rate cuts work to boost economic growth, thereby undermining the forecast.  Perhaps the Fed forecasted rate cuts to placate Congress and the Administration in this Presidential election year.  The idea may have been that promising rates cut in the near future would allow the Fed to hold policy steady through the election without being criticized for keeping policy too tight.   However, the built-in failure of this forward-announcing policy approach risks damaging the Fed's credibility.

 

 

The March CPI and Fed Policy

The stock market will likely shift its focus to the start of Q124 corporate earnings releases (which are likely to be strong and a market positive), as the Middle East situation appears to be stabilizing.  Oil prices will be an important monitor of the "temperature" in the region.  A decline would signal an easing in the region's tensions -- a positive for stocks.  Oil prices would need to stay high for awhile to have a significant impact on the US economy -- lifting inflation and hurting growth.   So, the Fed should also just watch the situation and not react to it.  Away from the Mideast, the Fed should think twice before changing policy intentions as a result of  the high March CPI.  The high print can be attributed to factors that are independent of aggregate demand or monetary policy.

The CPI measures price changes that could reflect inflationary pressures and/or relative price changes.  The latter results from factors specific to the demand/supply of an item and not an issue for monetary policy.   The culprits behind the higher-than-consensus 0.4% m/m increase in the Core CPI -- Motor Vehicle Insurance and Motor Vehicle Repair -- could be such industry-specific relative price changes.  If they had increased at the same rate as their prior 3-month averages, the Core CPI would have printed the consensus 0.3%.  If they were unchanged in March, the Core would have printed 0.2%. 

According to news stories, "extreme weather, driving habits and high repair costs" have been behind the sharp increase in auto insurance rates.  Motor repair costs have soared because /1/ modern cars are more complex, /2/ ongoing supply chain issues, /3/ shortages of trained technicians, and /4/ older cars need more repair work, made more important by the shift to used car sales.  These reasons suggest that at least some of the recently large increases in these components can be considered a result of factors specific to these industries. 

The jumps in Motor Vehicle Insurance and Repair in March could be one-offs and thus noise.  From a wider perspective, there always will be noise in the measurement of the CPI.  The real problem with the March Core CPI is that it would have been above the Fed's desired pace of 0.2% m/m even if these two components had risen in line with their recent trends.  

The Fed's goal is presumably to get noisy elements to push the CPI around a 0.2% m/m trend-line rather than 0.3%.  It's encouraging in this regard that more than half of the CPI components printed 0.2% or less in March.  However, it is still problematic that the largest CPI component, Owners' Equivalent Rent (OER), is trending 0.4%.  It may have to slow to 0.2-0.3% to lower the Core CPI trend to 0.2%.  This may happen yet, particularly if the CPI survey finally picks up the flattening in rent seen in private surveys.

There are two ironic aspects of OER: /1/ It is an imputed price, based on the CPI rent survey.  It measures what homeowners would pay if they rented their home.  Homeowners don't actually pay it.  This may be the reason why Fed Chair Powell highlights Core Inflation Less Shelter.  Why should the Fed restrain the economy for a price nobody pays?  /2/ Fed tightening can shift housing demand from ownership to renting, thereby pushing up rents.  So, it is questionable that Fed policy can do much to slow OER short of weakening the overall economy.  

With all the many specific factors impacting the components of the CPI and the largest component, OER, being more theoretical than real, Fed policy may do best by focusing on the broadest factor impacting prices -- labor costs.  So far, they appear to be in line with the Fed's inflation goal, taking account of productivity growth.  They argue for steady monetary policy at this point.  And, they keep open the door for Fed rate cuts if economic growth weakens.  

The Atlanta Fed model's latest estimate of 2.4% for Q124 Real GDP Growth is slower than the 3.4% Q423 pace -- which is a positive for the Fed but not weak enough to warrant rate cuts.  The questions now are the strength and duration of a post-winter bounce in Q224.  At this point, there is not enough evidence  to answer these questions.  So, Fed rate cuts remain hypothetical.

A Temporary Breather For Stocks

The stock market will likely continue to contend with higher oil prices and longer-term Treasury yields this week.  But, the rally could rekindle with the earnings season.

To some extent, the higher oil prices and yields are not entirely bad for stocks if, as is likely, a post-winter speedup in economic activity is a factor behind them.  They act like "built-in stabilizers" to restrain the latter, allowing the Fed to maintain steady policy through a possibly temporary bounce in the economy.  This week's US macro-economic data should keep policymakers in a wait-and-see position as well as keeping alive expectations of rate cuts ahead.  Meanwhile, the macro evidence suggest a strong Q124 corporate earnings season this month.

 March CPI

The consensus estimate of +0.3% m/m for both Total and Core CPI for March seems reasonable.  Both would slow from February's 0.4% pace.  The y/y would increase to 3.4% from 3.2% for Total and be steady at 3.8% for Core.   Oil-related energy prices (gasoline and heating oil) should slow, helping to hold down the Total.  (Seasonal factors offset most of the increase seen in gasoline prices at the pump.  So far, this offset is the case for April, as well.)  The Core CPI should not be boosted as much by airfares as in February, since seasonal factors provide less of a lift in March than they did then.  Most other components should be similar to their recent trends.  A slowdown in Owners' Equivalent Rent from 0.4% may be needed to push down the Core further.    

March Employment Report

The March Employment Report had more benign than worrisome components from the Fed's perspective.  Although Payrolls were strong, about half the increase was in non-economic sectors -- government and health care.  The sectors susceptible to monetary policy show the jobs slowdown desired by the Fed.  Nevertheless, the Nonfarm Workweek recovered back to trend, thereby pointing to a post-winter speedup in economic growth going into the Spring.   A steady Workweek in coming months would suggest the speedup is temporary.  

Other parts of the Report were benign.  The dip in the Unemployment Rate to 3.8% from 3.9% kept it above the 3.7% November-January level.  So, it still shows that labor market slack has increased.  This is also seen in the steady 7.3% U-6 Rate -- a broader measure of the labor market than the Unemployment Rate.  Perhaps thanks to the easier labor market conditions, wage inflation remains contained.  The 0.3% m/m increase in Average Hourly Earnings equals the 2023 average and Q124 average.  It is consistent with the Fed's 2% price inflation target, taking account of productivity growth. 

Q124 Corporate Earnings

Market participants look for about +3.0% y/y in S&P  500 corporate earnings for Q124, after about +8.0% in Q423.  The macroeconomic evidence suggest the risk is for a larger-than-expected gain.  Real GDP sped up on a y/y basis in Q124, oil prices reversed their decline, and economic activity abroad appears to have picked up while the trade-weighted dollar was flat.  Profit margins may have narrowed, however, as the Core CPI rose by less than Average Hourly Earnings.

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

Q122            3.5                  63.4                +2.7                              5.4           6.4               57.8  

Q222            1.8                  60.9                +5.3                              5.3           6.0               53.9

Q322            1.9                  31.9                +9.0                              5.1           6.3               49.3

Q422            0.9                    6.7                +8.9                              4.9           6.0               47.1    

 

Q123            1.9                -19.5                 +3.0                              4.5           5.5               47.9 

Q223            2.4                -32.0                 +0.5                              4.4           5.2               44.7

Q323            2.9                -12.0                 -2.5                               4.3           4.4               43.2

Q423            3.1                -12.0                 -2.5                               4.3           3.9               43.8

 

Q124            3.2                 14.0                   0.0                               4.3           3.8               46.3                                              

                                                                           

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

 

More Favorable US Economic Data Expected This Week, But...

The stock market should continue to be helped this week by macroeconomic data if consensus estimates are correct.  In particular, estimates of the key components of the March Employment Report point to slower economic growth and inflation.   They support the Fed's projection of rate cuts later this year.  However, there are some market-negative risks to the estimates.  And, even if the estimates are correct, they may not be soft enough for the Fed to commit itself to a near-term cut.  

Consensus looks for a slowdown in Nonfarm Payrolls to about +200k m/m in March from +275k in February.  The jobs slowdown would be in the right direction, but still solid.  Consensus-like prints of the other important data in the Employment Report should allay concern about the jobs' strength.  The Unemployment Rate is seen staying at 3.9% -- the high end of its recent range -- and Average Hourly Earnings (AHE) is seen contained at 0.3% m/m (although up from the low 0.1% in February).  A 0.3% print for AHE would equal trend and be in line with the Fed's 2% price inflation target, taking account of productivity growth. 

The Claims data support an expectation of a smaller Payroll gain than January's +275k  Although Initial fell a bit in March, indicating fewer layoffs, Continuing rose, suggesting even less hiring.  While there is no reliable evidence regarding the Unemployment Rate or AHE, some unwinding of the big February moves is conceivable -- a potentially negative risk for the market.  A dip in the Unemployment Rate and a speedup in AHE to an above-consensus print are conceivable after their big moves in February.  They could trigger a negative market reaction to the Report.  But, the reaction could be short-lived, as the unfavorable prints should probably be viewed as partly noise.  And, a modest unwinding of their February moves would not significantly change the story of slower growth and inflation.  A dip to 3.8% would keep the Unemployment Rate above its prior 3-month average.  Any print below 0.5% for AHE should lower the y/y. 

Last week's report on the February PCE Deflator kept alive the idea of Fed rate cuts ahead, as. the 0.3% m/m Core PCE Deflator was encouraging in several respects.  The un-rounded increase was even lower at 0.26%.  And, the Market-Based Core PCE Deflator rose only 0.2%.  Over the first two months of the year, both Total and Core are running below last year's pace.

Rising commodity prices remain a potential problem for the inflation outlook.  Higher commodity prices can feed through to the CPI as they are passed through to the consumer.  Some of the recent increase in these prices is seasonal, however.  For example, retail gasoline prices jumped 6.4% m/m in March but only 1.8% after seasonal adjustment.   However, another factor behind their increase could be higher demand either domestically or abroad, perhaps reflecting a post-winter bounce-back in economic activity.  Economic activity appears to have improved in China in March.  Stronger growth into the Spring would likely keep the Fed from easing. 

 

Key Data Should Help Stocks This Week

The stock market should continue to climb this week, as the key February PCE Deflator is likely to better conform to the Fed's anti-inflation goal than the CPI.  Along with a modest increase in consumer spending that month, it should encourage market expectations that the Fed will follow through with its rate cut forecast at some point this year.  

Consensus looks for +0.4% m/m Total PCE Deflator and +0.3% Core, the latter being slightly lower than the 0.4% print for the Core CPI.  The risk is that Total and Core PCE Deflator come in below consensus.  The y/y should tick up for Total and tick down for Core, based on the consensus estimates and assuming no revisions to prior months.  The latter is possible, though.

Consensus expects a 0.4% m/m increase in Consumer Spending, after a 0.2% increase in January.  However,  there should be a downward revision to January Consumer Spending, based on the large downward revisions to January Retail Sales and Payroll Growth.  So, even with a February speedup, the data should suggest a slowdown in Consumer Spending in Q124 from 3.0% (q/q, saar) in Q423. 

Fed Chair Powell pointed out at his news conference that last year's path of inflation would suggest the high January-February CPI prints were "bumps" on the road to subdued inflation.  They were high in 2023 too and were followed by soft prints for the rest of the year.  In terms of the PCE Deflator, the m/m change in both Total and Core averaged 0.2% m/m from March through December after 0.5% on average in January-February.  Remarkably, these measures of inflation was close to the Fed's target in all but the first two months of 2023!  The annualized inflation rate for Total was 2.1% over the last 10 months of the year while the rate for Core was 2.5%.  For the full year, the inflation rate was 2.6% for Total and 2.9% for Core.

While a similar pattern is desirable for 2024, note that it could be difficult to bring down the y/y change from its February level for the rest of the year.   Regarding the 2023 pattern, it is encouraging that the PCE Deflator rose by less in January 2024 than in January 2023.   Consensus for February 2024 is slightly higher for Total and slightly lower for Core than last year, but the risk is that both will be below last year's prints.  .So, perhaps Total and Core Inflation will continue to be softer in the last ten months of 2024 than last year and hit the Fed's target?.

However, there are some potential problems.  First, softer inflation prints will likely require a slowdown in Owners' Equivalent Rent from the +0.5% m/m 2023 average.  This was not the case for the January-February 2024 average.  And, the speedup in Primary Rent in the February 2024 CPI was not a good sign. Second, commodity prices have to be subdued.  The recent run-up in oil prices is concerning in this regard.  It could filter through to airfares and other components of the Core CPI and PCE Deflator.

This Week's FOMC Meeting

The stock market will likely take this week's FOMC Meeting in stride, as the Fed's economic and policy outlook should not change fundamentally. 

The FOMC Central Tendency Forecasts still should expect slower growth and inflation in 2024 and two-three rate cuts.  Although recent data have been somewhat problematic with regard to this outlook, some of the difficulty may be temporary and, more importantly, it is too soon in the year for the Fed to react significantly to them.  In addition, lifting the inflation forecast could have adverse effects on its anti-inflation fight, as discussed below.  In any case, it is not clear whether the Fed's economic outlook for 2024 will work out or not.  This uncertainty should dampen any market reaction to the Fed's forecast. 

Evidence on the real-side of the economy so far is not out of line with the Fed's Central Tendency Forecast for 2024 made in December.  The Atlanta Fed model's forecast of 2.3% for the Q124 Real GDP is close to the 1.7% high end of the Central Tendency Forecast, while the 3.9% February Unemployment Rate is at the low end of the Forecast.  At this point, the Fed's 2024 forecasts of Real GDP Growth and the Unemployment Rate look attainable.  However, the markets still can't be certain this will be the case.  Indeed, there are signs of faster economic growth from Unemployment Claims, the Phil Fed Leading Index of Capital Spending, and commodity prices.  A weather-related bounce-back into the Spring, particularly in Retail Sales, is possible.  And, fiscal stimulus remains in effect.

Evidence on inflation has not been as soft as desired.  But, some of the high prints for the CPI and PPI could have resulted from one-off start-of-year price hikes.  And, the y/y increase in the Fed's favored Core PCE Deflator Less Shelter remained close to the Fed's 2% target, at 2.2%.  It will be important to see if wage inflation is contained ahead.  Higher unemployment helps, but statutory increases in the Minimum Wage work against it.  A slowdown in housing rent also is critical.  Although Owners' Equivalent Rent fell back to 0.4% m/m in February from January's 0.6%, it is somewhat disconcerting that Primary Rent sped up.  So, it's not clear that the Fed's inflation outlook will work out.  On a positive note, longer-term inflation expectations so far in check, according to the University of Michigan Consumer Sentiment Survey

Aside from the data, there could be a couple of problems for the Fed if it raises its inflation forecast.  They could make its anti-inflation fight more difficult to win.  /1/ Its rationale for cutting rates this year -- that keeping rates steady in the face of falling inflation would raise real interest rates -- could be undermined.  Steady rates with higher inflation would lower real rates -- and boost economic activity.  /2/ It could lift inflation expectations, thereby exacerbating the risk of a wage-price spiral.  These are reasons for the Fed not to raise its inflation forecast at this time.

Fed Chair Powell has indicated patience in achieving the Fed's goal and that a sense inflation is moving in the right direction may be enough to allow for a rate cut.  He may emphasize the need to see weaker economic growth to be comfortable with cutting rates.  Declining commodity prices and bond yields would provide supportive evidence.  They are not happening yet, but important to watch for.

 

Inflation Next

The stock market should take Tuesday's release of the February CPI in stride if consensus estimates print, but the latter can't be taken for granted.  A consensus-like print would likely translate into a smaller increase in the PCE Deflator.  In the background, Powell's testimony last week and the February Employment Report keep open the door for Fed rate cuts by mid year -- a positive for stocks. 

The consensus estimates of the February CPI (+0.4% m/m Total, +0.3% Core) look reasonable, but they may require Owners' Equivalent Rent (OER) falling back to +0.4% from the extraordinary +0.6% in January and most other components flattening.  There is upside risk to Core if less favorable prints are the case.  Indeed, last year, the Core CPI sped up in February after a high January increase.  A component that contributed to the high February Core then was Airfares.  This year, a reduction in the fuel surcharge tax could hold it down.  The y/y for Core CPI should fall somewhat from 3.9% in January. 

The February Employment Report is Fed-friendly and could encourage officials to think of a possible rate cut by mid year.  Nonetheless, the latter will probably require additional evidence that economic growth is slowing and inflation trending down.  The increase in Continuing Unemployment Insurance Claims over the past two weeks supports this possibility.

On its surface, the +275k m/m increase in February Nonfarm Payrolls is stronger than desired by the Fed.  It is well above the 100k area that would clearly show a softening labor market and exceeds the +212k m/m Q423 average.  But, more than half of the February Payroll strength resulted from large gains in non-economic sectors, such as health care and government.  Some of the strength also might reflect one-off rebounds from adverse weather effects in January.  A weather rebound also could explain the bounce-back in the Nonfarm Workweek to 34.3 Hours from an upward-revised 34.2 Hours in January (was 34.1 Hours).  The Workweek in both months remain below the earlier 34.4 trend and still suggest softer demand for labor.  The large downward revision to +229k from +353k in January Payrolls confirms that measurement error was largely responsible for the surprising initial print.

The Household Survey data tend to be less affected by weather than Establishment Survey data.  So, the decline in Civilian Employment -- the 3rd m/m decline in a row -- offers reasonably significant evidence of a weakening labor market.  The latter is reflected in the jump in the Unemployment Rate to 3.9% -- a good move from the Fed's perspective.

A softer labor market may be one reason for the low +0.1% m/m increase in Average Hourly Earnings (AHE) in February, after a downward-revised +0.5% in January (was +0.6%).  The low February print alternatively may be just an offset to the January jump, with the 2-month average equaling trend.  This would not be a bad result.  The 0.3% m/m 3-month average of AHE is consistent with the Fed's 2% price inflation target, taking account of productivity growth.