A Friendly FOMC?

The stock market may resume its rally this week, as the Israeli-Iran attack may move to the background at least for now and the Fed becomes center of attention.  There is a possibility the Fed may begin to tilt toward an easing at this week's FOMC Meeting.  This could be seen in the Statement as well as in Fed Chair Powell's post-FOMC news conference.  

The FOMC Statement might tone down its description of inflation, given the low CPI prints of the past two months.  In May, the Statement said, "Inflation remains somewhat elevated."  Perhaps this remains true for the Core PCE Deflator on a y/y basis, but not the Total PCE Deflator (see below).  The Statement also might modify its description of the balance of risks.  In May, it said it "judges the risks of higher unemployment and higher inflation have risen."  Tariff-related risks to both remain, but the evidence is building towards the former rather than the latter

The Fed is in a delicate situation with regard to monetary policy.  The latest evidence of slowing inflation and possibly slowing economic growth opens the door for rate cuts at some point.  However, a Fed shift in that direction risks the impression of bowing to political pressure from Trump.  To be sure, even a hint that the next move will be an easing could elicit a complaint from Trump that the Fed is dragging its heels.  And, it is likely that any hint would probably be balanced by tariff-related uncertainty.  Still, any hint of easing would be a market positive.

The US economy appears to be evolving along the lines of, if not better than, the Fed's Central Tendency Projections made in March (see table below), which embody expectations of 1-2 rate cuts in H225.  Real GDP Growth in H125 is 1.8%, assuming the Atlanta Fed Model's latest projection of 3.8% for Q225 (after -0.2% in Q125).  The 1.8% H125 average pace, which smooths out weather and other temporary effects, matches the Fed's estimate of the longer-run trend in Real GDP.  Meanwhile, inflation is behaving better than expected by the Fed.  April's y/y is 2.1% for the PCE Deflator and 2.5% for Core -- both below the Central Tendency Forecasts.  Powell may bite the bullet and recognize the desired behavior of the US economy and what it implies for monetary policy.  

                                      Fed's Central Tendency Projections for 2025 (Q4/Q4 % Change) 

 Real GDP Growth                  1.5-1.9      

PCE Deflator                           2.6-2.9  

Core PCE Deflator                  2.7-3.0 

Evidence pointing to a slowdown in economic growth from the Q225 pace is building.  Initial and Continuing Unemployment Insurance Claims have climbed over the past three weeks.  The latest week's Claims data are above their respective May averages.  This week's US economic data could add to this evidence.  In particular, consensus looks for a slight 0.1% m/m increase in May Ex Auto Retail Sales, the same as in April.  Not too much should be made of a soft print, since it could be attributed to the typical pause after a strong month (March).  Nevertheless,  it would keep open the door for slower growth ahead.  In contrast, a large gain could bolster expectations of a sustained strong pace of economic activity. 

  

 

Inflation Next, Growth and Federal Deficit in Background

The stock market may continue to rally this week, as US inflation data are expected to remain contained despite the beginning impact of tariffs and a post-winter rebound in economic activity.  Controversy over Trump's tax bill should bubble in the background, with a self-imposed passage deadline of July 4.

Consensus expects a moderate May CPI, with Total up 0.2% m/m and Core up 0.3%.  This month's report should begin to pick up the pass-through of Trump's tariffs to prices.  However, other forces are at work, as well, including subdued oil prices, compositional shifts in demand for goods and services, and contained wage inflation.  In particular, all three factors and seasonal factors could depress airfares again, as they did in the prior two months.   Also, housing rents may be finally reflecting the softness seen in private surveys months ago.  So, a lower-than-consensus May CPI can't be ruled out.

The May Employment Report confirmed a post-winter rebound in economic activity in Q225 but left open the door for slower growth in Q325.  Total Hours Worked (THW) in May stood 2.4% (annualized) above the Q125 average, markedly better than the +0.7% (q/q, saar) pace in Q125.  This is consistent with the Atlanta Fed Model's latest estimate of +3.8% (q/q, saar) Real GDP Growth in Q225, assuming a boost from productivity.  However, THW in May were only 0.2% (annualized) above the April-May average.  Unless there is a bounce in at least one of the next few months, THW could slow sharply in Q325.  The still-high level of Unemployment Claims for the second week in a row supports this possibility.

The Employment Report also showed that wage inflation remained in its recent range.  Although Average Hourly Earnings ticked up to 0.4% in May, this followed a low 0.2% in April.  The April-May average is 0.3%, equal to the recent trend.  And, the uptick in the unrounded Unemployment Rate to 4.24% from 4.19% suggests upward pressure on wages remains modest.  The question ahead is whether tariff-related boosts to prices lead to a ratcheting up in wage demands as labor tries to recoup its purchasing power.

There are two aspects of the Federal Deficit debate that are relevant for the markets.  One is the sequential change in the Deficit.  The other is the longer-run sustainability of US debt, that is whether investors -- domestic and foreign -- will want to hold the debt around the current level of interest rates.   

A sequential decline in the Federal Deficit would hurt US economic growth.  There would be a substantial drag if the 2017 tax cuts are not extended.  Cuts in Federal subsidies and transfer payments would hurt growth, as well.  An extension of the tax cuts would have little impact on growth, as there would be no increase in fiscal thrust.

The longer-run sustainability of the Federal Deficit has been an issue forever.  So far, the US economy has not collapsed as a result.  Continuing Federal Deficits have been possible because the US dollar is the most important global currency and foreigners need it, either for transactional or storage purposes.  

Investors have been willing to hold US debt and other assets, in part because of a reliable legal system, respect for property rights, and a government constrained by checks and balances in the US.  If investors lose faith in US institutions or policies, then the huge amount of outstanding debt will be a problem.  The sale of US assets -- stocks, bonds and currency -- would push the US economy into recession.  It's not clear the Fed would be able to withstand it if the magnitude of selling is large.  So, while cutting the Federal Deficit would likely be viewed positively by the markets,  if it is not, doomsday prognoses are probably overdone as long as US institutions remain highly respected.  The Fed's independence is one such institution that needs to be maintained.

 

 

   

 

 

  

The Economic Picture In The Background

The stock market is likely to continue being pushed around by positive and negative developments in the tariff war.  Nevertheless, the market still has its eye on the economy in the background, looking for evidence that the tariffs, either themselves or uncertainty surrounding them, damage growth prospects.  This week's key US economic data are not expected to provide such evidence,  Both the May Employment Report and Mfg ISM are seen indicative of moderate economic growth.  So, the macro background is still supportive of stocks.

Consensus looks for a slowdown in Nonfarm Payrolls to +130k m/m in May from +177k in April.  The expected May pace would be consistent with a steady 4.2% Unemployment Rate, which is the consensus estimate.  Such a level of unemployment is historically low but shows some slack relative to last year.  And, as Fed Chair Powell has said, there is little evidence that wage gains have generated inflationary pressures.  That is, a wage-price spiral is not evident.  The consensus estimate of +0.3% m/m for Average Hourly Earnings is consistent with the Fed's 2% inflation target, taking account of trend productivity growth.  The y/y would fall to 3.7% from 3.8% if consensus prints.

The Claims data support the idea of a slowdown in May Payrolls.  Both Initial and Continuing have trended above their levels in the April Payroll Survey Week, suggesting a pickup in layoffs and softening in hiring.  Both jumped in the latest week, but more weeks at the higher levels are needed to confirm their  import.

The consensus estimate of a steady 48.7 for the May Mfg ISM would be consistent with sluggish but non-recessionary growth in the manufacturing sector.  It would remain below the 50.1 Q125 average.  This sector is particularly vulnerable to the tariff war, impacted by higher input costs and potential loss of export markets.  To be sure, the weaker dollar could have helped some industries,

The Atlanta Fed Model's latest projection of Q125 Real GDP Growth is a strong 3.3% (q/q, saar).  The strength largely reflects the drop in April Imports.  This is a mirror image of what happened in Q125, when a surge in imports pulled down Real GDP to -0.2%.  Both figures likely reflect measurement problems when there are large swings in imports.  The best way to evaluate recent GDP Growth is to average the two quarters.  Using the latest Atlanta Fed Model estimate, Real GDP Growth in H125 is about 1.5%.  This is close to the longer-run trend estimated by the Fed and is not an inflationary pace.   

A Tariff Threat and House Bill -- Market Problems?

The stock market may brush aside Trump's apparently "shoot from the hip" tariff announcements after he postponed his latest tariff threat to the EU.   His initial threats appear to be for shock value, to be restrained by his advisors afterwards.  They seem to have a "transactional" goal in mind.  Whether his new July 9th deadline results in a deal or not, it is far enough away for the issue to move to the back burner for the market for now. 

Meanwhile, the House tax bill appears to be fairly neutral for the economy and stock market.  Most of the provisions just make permanent tax provisions that have been in place since 2017.  So, there is little net fiscal thrust from them.  Instead, the cuts to some entitlement programs are a drag on aggregate demand.  And, new spending projects, like "Golden Dome," run into the same problem as Trump's desire to re-shoring manufacturing production from abroad -- other spending would be "crowed out" while the economy is operating near full capacity.   This would be accomplished through higher inflation and Treasury yields, stronger dollar, and/or lower stocks.  In any case, it is still a work in progress, with the Senate expected to make some changes to it.

The possibility of inflationary pressures from Trump's initiatives is a potential negative for stocks, kept in play by longer-term Treasury yields staying high.  To be sure, there could be relief if it turns out that re-shoring or building a defensive system takes a long time to build, so the pressure on resources does not show up quickly.   

There could be relief this week as consensus expects soft prints for this week's US economic data.  Consensus sees flat April Durable Goods Orders Excluding Transportation, after -0.4% m/m in March.  Uncertainty about Trump's tariffs could continue to weigh on them for a few more months.  April Personal Spending is expected to slow to  +0.2% m/m from +0.7% in March -- a pause from a strong post-winter bounce.  And, the April Core PCE Deflator is seen at a low 0.1% m/m, in line with the June CPI.  Boosts from tariffs are likely to begin to be seen in the May CPI, due in June.

 

Focus on Federal Deficit, But Stronger US Economic Growth Ahead?

The stock market may focus on Congressional efforts to forge a budget, now that Moody's downgraded the US because of the unchecked outlook for the federal deficit.  With the House Budget Committee failing to agree on a budget last week, the question is whether or how will taxes be raised or federal spending cut.  Trump presumably will weigh in on the deliberations.  From the stock market perspective, the best outcome would likely be skewed toward spending cuts and a reduction in the 10-year projection of the federal deficit.  Indeed, the Moody's downgrade could be viewed a market positive for putting pressure on Congress to cut the deficit.  Nevertheless, budget-related flareups in the stock market never last.  So, a pullback is probably a buying opportunity.

Once the budget issue is resolved,  stocks may be supported by expectations of stronger economic growth ahead.  Increased business investment and net exports, along with a shift away from imports to domestic production, may turn the consensus outlook away from recession.  In such a turn-about the market may begin to consider a tightening as the next Fed policy move.  Whatever the Fed's next move, it will not likely be an imminent risk until late this year if at all.  

The fear of recession stemming out of Trump's tariffs has abated since he pulled back on the bulk of Chinese tariffs.  There will be less of a tax on consumers than what was feared.  Moreover, the re-shoring of production by companies and the planned investments in plant and equipment to do so will boost economic activity ahead.  And, US exports will be helped by Trump's deals with other countries, such as the 210 Boeing plane order by Qatar, as well as by the recently softer dollar in the FX market.

These boosts to economic activity may not fully boost GDP.   They could "crowd out" other sources of demand, if, as is case now, the US economy is operating close to full capacity.  Higher longer-term yields would weigh on housing and other interest-sensitive spending.  Higher inflation would hurt the consumer.

One US economic data release that could become important to watch is Durable Goods Orders.  (April Durable Goods Orders will be released May 27.)   They contain information regarding capital spending.  It may take several months before they show a pickup in the latter, since the uncertainty and recession fears stemming from Trump's initial tariff announcements likely had businesses pull back in a wait and see posture.   A leading indicator of capital spending in the Philadelphia Fed Manufacturing Survey points to a softening in capital spending into the summer before a rebound.

Construction Spending, typically not given much attention by the markets, will contain information on factory and warehouse building.  These could be a catalyst for growth, as well. 

Another important economic data release will be the Trade Deficit.  A positive for the US economic outlook would be a speedup in exports and a slowdown in imports.  This will be difficult to judge, since both exports and imports surged in Q125 in anticipation of tariffs here and abroad.  In 2024, exports rose 2.4% while imports rose 12.2%.  In Q125, exports rose 4.6% and imports rose 14.9%.  There could be a pullback in both toward longer-term trends in the next quarter or two.

A move toward closing the door on foreign competition, which is what tariffs do, could have an indirect effect on inflation.  By shielding US workers from having to compete with lower-paid foreign workers, US labor may increase their wage demands.  Fed officials, including Powell, have attributed the benign wage inflation despite lower unemployment to the Fed's success in holding down longer-term inflation expectations.  However, it also could have been a result of competition from low-cost labor abroad.  And, if the latter eases up, wage inflation may pick up.

 

 

 

 

 

 

 

 

Tempered Tariffs?

The stock market may continue to be buoyed this week by talk or reports of more trade deals and a cut in Chinese tariffs.  They suggest the bite from tariffs may be less than the worst feared.  To be sure, this weekend's US/China negotiations need to have gone well.  The slew of US economic data this week may be taken in stride, as they could be too early to show the tariffs' impacts.  

The UK trade agreement and Trump's expected backtracking of Chinese tariffs still leave tariffs in place, with their threat of higher US inflation and slower economic growth.  However, both should temper the extreme concerns expressed by some regarding the fall-out from the tariffs.  Indeed, Fed Chair Powell said in his post-FOMC news conference that tariff negotiations could result in a smaller-than-expected boost to inflation.  If the fall-out turns out to be modest, it would probably be seen by late summer or fall.  By then, the fall-out would likely have to be pitted against the federal spending and tax cuts now being considered in Congress.  If the bulk of the tax cuts just extend current law, their impact on the economy could be modest, as well.  In this case, the Fed may not have a compelling economic reason to change policy.

Most of this week's US economic data are for the month of April, when some of the tariffs may have just begun to hit.  The consensus estimates for the April CPI appear to reflect this possibility, as both Total and Core are seen rising 0.3% m/m after the low March prints (-0.1% Total and +0.1% Core).  There is a risk, however, that consensus is too high, as some of the reasons for the low March prints may recur in April, particularly the decline in Airfares. Although the Manheim Survey shows a jump in Used Car Prices in April, these are at the wholesale level and tend to be seen in retail prices with a lag.  

Consensus looks for modest economic growth-related data -- April Retail Sales, Industrial Production and Housing Starts/Permits.  A slowdown could reflect drags from the tariff threat, but not necessarily.  Retail Sales are expected to slow to +0.1% m/m Total (versus +1.5% in March) and +0.3% Ex Auto (versus +0.6% in March).  This could be the typical easing after strong prior gains, so should not be viewed with concern.  A stronger-than-consensus print can't be ruled out, nonetheless, as anticipatory buying ahead of the tariffs could have extended into this month.  Industrial Production is expected to edge up 0.1% m/m after +0.3% in March.  The risk is for a decline, based on Total Hours Worked in Manufacturing last month.   Consensus also looks for little change in April Housing Starts/Permits, which, in the 1.3-1.45 range, have been well below the 1.6 Mn Unit level needed to supply long-term demand.

Unemployment Claims data remain important to watch.  The latest data show an unwinding back to trend of the prior week's jumps in Initial and Continuing (suggesting the latter resulted from a technical factor).  Powell mentioned that the Claims data remain low, indicative of a strong labor market.  Powell also downplayed the -0.3% (q.q, saar) dip in Q125 Real GDP, blaming it on the difficulty of capturing the large swing in imports.  An unwinding of the import surge could result in a bounce in GDP in Q225 or Q325.  The Atlanta Fed Model latest estimate of Q225 Real GDP Growth is +2.3%.

 

 

 

Stock Rally To Continue?

The stock market may continue to rally this week, as resolution of the tariff issue appears to be moving ahead.  The market is likely to become more focused on the fall-out from the tariffs.  There are two questions:  /1/ What is the direct boost to inflation and hit to economic activity? /2/ Will the direct hits develop into a wage-price spiral and/or recession.  It will take time to answer them.  So, the questions should be more in the background for awhile.

The direct hit to prices from tariffs begin mostly in May.  While there should be a lot of anecdotal evidence regarding their impact on prices, the May CPI will be released in June.  Meanwhile, the April CPI, due May 13,  risks being benign, held down by the pass-through of lower oil prices and anticipatory price cutting by motor vehicle companies.  The April Employment Report shows that wage inflation remains subdued, which should help hold down the CPI, as well.

The April Employment Report also suggests that economic activity was set to bounce back in Q225 ahead of the tariffs.  The +177k m/m increase in Nonfarm Payrolls exceeded the +164k 2024 average.  Total Hours Worked in April were 2.0% (annualized) above the Q125 average, a speedup from +0.8% (q/q saar, revised up from 0.5%) in Q125.  The jump in Initial and Continuing Claims in the last week of April, however, raised the risk that the bounce-back will be short lived.  To be sure, it is somewhat suspicious that both Initial and Continuing jumped in the week.  Continuing tends to lag Initial.  Some technical factor may have been behind both jumps.  So, their higher levels have to confirmed in this week's release.

The -0.3% dip in Q125 Real GDP also looks suspicious, since most of the weakness was in a surge in imports ahead of the tariffs.  It would seem reasonable that most of the surge should have found its way into inventories.  (To be sure, some of the import surge fed into business equipment spending, part of which is calculated directly from net imports.)  While inventories were up a lot, the surveys from which they are measured may not have picked up all of them.  It remains to be seen whether inventory investment gets revised up significantly.  If not, it wouldn't be the first time that sharp changes in Net Exports had questionable impacts on GDP.

So far, the Payroll data do not show a significant number of job cuts in the federal government.  They fell 9k in April and down 26k since January.  One reason is that the 75k workers who are receiving ongoing severance pay are counted as employed.  There should be a large drop in Federal Government Payrolls once their severance pay ends.