A Fed Rate Skip, What's Next?

The stock market may view this week's FOMC outcome as a non-event if the Fed decides to skip a rate hike.  The market focus should continue to be aimed at Iran war developments and the mid-term elections.  

Two major macro questions regarding the post-election situation are /1/ whether the Iran war will expand or be resolved and /2/ whether and by how much will the Fed tighten ahead.   Reports of US-Israeli plans for a short strike is a negative for the market outlook.  However, reports of continuing US-Iranian negotiations keep open the possibility of a peaceful resolution.  As for future Fed policy moves, a significant slowdown in inflation is likely needed to prevent the Fed from tightening.  Otherwise, at least one more rate hike is the risk, given that Fed Chair Warsh has said that even steady above-target inflation is unacceptable. 

As for this week's FOMC Meeting, the Fed can justify a pause in tightening by arguing the recent price shocks -- oil, tariffs -- are largely beyond their control.  With little if any inflationary pressure coming from the labor market, it can wait to see how the fall-out from the shocks evolve.  Weakening the labor market, which further tightening would lead to, may not be needed to lower inflation over time if the shocks begin to unwind.  The strong dollar meanwhile is working to hold down inflation already.  These arguments could allow them to avoid  the politically-problematic choice of hiking rates in front of the mid-term elections.

A problematic labor market also could help persuade the Fed to hold off on hiking at this meeting.  Although layoffs are down, seen in the decline in Initial Unemployment Claims, hiring may have slowed as well, seen in the increase in Continuing Claims.  So far in October, Initial Claims are below their September average while Continuing are above theirs.   At this point, the data suggest another sluggish Payroll increase in October.  The slowdown in wage inflation, reflected in Average Hourly Earnings in Q326 and the broader Compensation/Hour in H126, may attest to the pullback in labor demand by companies.

Strong Productivity Growth may be substituting for job growth, possibly AI-related.  If this week's release of the first report on Q326 Real GDP Growth is close to the 3.0% consensus estimate (Atlanta Fed model's estimate is 3.5%), Nonfarm Productivity Growth should be better than the 1.1% pace in H126 and possibly in line with the strong 2+% trend seen since 2024.  Unit Labor Costs could come in below 2.0%, as in H126, and remain consistent with 2% price inflation -- attesting to the Fed's view that inflationary pressures are not emanating from the labor market.  To be sure, the costs of using AI offset some of the labor cost savings.

The consensus estimate of the September PCE Deflator is similar to the high CPI for the month.  Consensus looks for +0.5% m/m Total and +0.3% Core PCE Deflator.  The y/y for Core is seen edging up to 3.1% from 3.0%.  However, like the CPI, much of the Core's increase can be traced to the oil/tariff price shocks and AI-related shortages of computer parts.  So, this Report is not likely to change Fed views of the inflation outlook.  The hawks will see reason to hike while the Doves will hold to the hope that effects of the shocks wear off by next year.  Note that Fed Chair Warsh could announce the Fed staff's estimate of the September PCE at the post-FOMC news conference, as has been the practice.  The PCE Deflator will be released the next day.

 

 

 

 

Inflation And The Fed

The stock market may continue to be weighed down by concerns regarding AI, Iran war and the Fed this week, after last week's data releases underscored a persistent inflation problem.  From the Fed's and market's perspectives, the question is whether non-economic factors -- AI, tariffs and Iran war -- are behind the high inflation prints and whether the impact from these factors will dissipate over time.  If this is the case, then a gradual approach to tightening would likely be appropriate.  A breakdown of the September CPI suggests these factors are playing a significant role but may not be the whole story.  It remains an open question whether the Fed will engage in only modest additional tightening after skipping a rate hike at the October 27-28 FOMC Meeting.

The high September CPI (+0.6% m/m Total and +0.3% Core) showed widespread price increases.  Two-thirds of the major Core components had increases that exceeded their prior 3-month average.  They appeared to be high for a variety of reasons, including AI, tariffs and the Iran war.

Some of the large price increases were just catch-up after declines or flat prints in prior months or by components that are typically volatile.  For example, a 2.0% jump in the volatile Lodging Away From Home -- all because of a boost from seasonal factors -- contributed a notable 0.04% pt to the Core CPI.  However, there is more to the story than just volatility in some components.  The Cleveland Fed's Trimmed Mean CPI -- which eliminates outliers -- sped up to 0.3% m/m from 0.2%.    

Many price increases could have resulted from AI-related shortages, e.g., computers (higher-priced memory), or from the jump in oil prices, e.g., airfares, intra- and inter-city transportation, delivery services and more.  The impact of higher oil prices, in particular, can lift the prices of a broad range of goods and services.  Fear of renewed fighting in the Iran war after the midterm elections should keep oil prices up for at least the next few weeks.  Computer memory prices, in contrast, appear to be falling gradually -- a good sign that the shortage is abating. 

AI is typically viewed as leading to higher productivity growth -- which would hold down inflation.  However, in the current early stage of AI adoption, firms may be using AI without reducing headcount.  They may be introducing AI cautiously.  With AI costly to use, it may be a factor lifting prices for now, as it may not be being offset by lower wages for some companies.  To be sure, AI could be a factor behind the recent slowdown in wage inflation.  (Average Hourly Earnings slowed to an annualized 2.4% in Q326 from 3.3% in the prior 4 quarters.)  With companies pulling back on hiring, either because AI substituted for labor or because of uncertainty about how AI will affect their need for workers, the ensuing weaker labor demand could be weighing on wage inflation.

One troubling speedup in the September CPI, not directly impacted by the non-economic factors, was Owners' Equivalent Rent (OER), which has a high weight in the CPI.  It reverted back to trend, rising 0.3% m/m in September after slowing to 0.2% in August.  The Core CPI would have rounded to 0.2% in September if OER rose only 0.2% and Lodging Away From Home was flat.  The trend in OER needs to slow to 0.1-0.2% for the Fed to achieve its 2% inflation target on a sustained basis.  If it does not, other prices need to slow below an annualized 2% pace to achieve the Fed's target -- arguing for more aggressive Fed tightening that would weaken economic activity.  To be sure, Primary and Owners' Equivalent Rent could be affected indirectly by oil prices to the extent that the latter is behind the rise in longer-term yields including mortgages.  A shift away from home ownership to renting as a result of the higher mortgage rates could put upward pressure on rents.  An end of the Iran war could lead to lower rents that help to hold down the CPI.

From the Fed's perspective, what's most important is preventing higher oil prices, because of their pervasive impact, from sparking a wage-price spiral.  This consequence does not appear imminent, despite the recent rise in inflation expectations, as wage inflation looks to be contained if not slowing.  So, the Fed can afford to skip hiking rates at the October FOMC Meeting if it wants and then resume tightening gradually at subsequent Meetings.  

 

 

 

 

 

This Week's Important US Economic Data

The stock market will face some important US economic data this week as a strong corporate earnings season gets underway.  Consensus expectations for the September CPI and Retail Sales, among other relevant but minor data, show that inflation remains high overall and sticky in the core as well as a continuing solid consumer.  This picture keeps open the door for more Fed tightening.  However, a consensus print for Core would likely allow the Fed to skip hiking rates at the October FOMC Meeting -- which would be a near-term positive for stocks.

Consensus looks for +0.6% m/m Total CPI and +0.2% for Core.  These estimates look reasonable.  Retail Gasoline prices jumped about 9% (sa) in September, which largely accounts for the jump in Total.  The higher gasoline prices could permeate through Core components, as well.  However, seasonal factors begin holding down Airfares this month after boosting them in the prior three months.  Seasonals boost Lodging Away From Home for the second month in a row, and this component could jump similarly to its 2% bound in August.  All these considerations add up to about 0.2% Core.  Nonetheless, the consensus estimate of an uptick in the y/y to 2.5% from 2.4% may be too high, depending on rounding.  An un-rounded m/m Core of 0.22% or lower would result in a steady 2.4% y/y, which the stock market may like.

Consensus looks for only a modest slowing in Retail Sales in September after they jumped in August.  Total Sales are seen up 0.3% m/m after +1.2% in August, while Ex Auto is seen +0.5% after +1.4%.  There is no consensus estimate for Auto/Ex Gasoline Sales, which jumped 1.2% m/m in August.  Even a modest increase in the latter would be notable, since a large increase can be followed by some payback in the following month.  At this point, Real Consumption looks to have expanded well over 3.0% (q/q, saar) in Q326 -- despite the weakness in surveys of consumer sentiment or confidence.

The University of Michigan Consumer Sentiment Index fell for the third consecutive month according to the Mid-October print reported Friday.  The weakness was in Current Conditions.  Importantly from the Fed's perspective, the longer-run 5-year Inflation Expectations measure rose to 3.5% from 3.4%, the highest since May and remaining above the pre-Iran war range of 2.8-3.2%.  It is not a good print from the perspective of the inflation hawks at the Fed.

 

Corporate Earnings and Fed Policy -- Near-Term Positives

The stock market may be buoyed in the next few weeks by two expectations -- strong Q326 corporate earnings and steady Fed policy at the October 27-28 FOMC Meeting.  These positive expectations could be tempered by a rise in longer-term Treasury yields.

 Corporate Earnings

Consensus looks for another quarter of huge earnings growth.  S&P 500 corporate earnings are expected to climb 23-29% (y/y) in Q326, lifted by strength in Information Technology and Energy.   This follows earnings growth of about 50% in Q226 and 28% in Q126.  The macroeconomic data support the idea of still strong earnings but not as strong as in Q226.  Real GDP Growth is seen slightly slower in Q326 than Q226 on a y/y basis.  Oil prices are still up sharply but not as much as in Q226.  The FX value of the dollar is a bit softer, making earnings abroad worth more in dollars, but not as much as in Q226 -- although this could be offset by an improvement in economic activity abroad in Q326.  Profit margins don't look to have improved, as the spread between the Core CPI and Average Hourly Earnings was steady after expanding in Q226.  

                                                                                                                                        Euro  Area   

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

                     [                y/y percent change                                                            ]          (level)

Q126            2.6               40.0                       -8.0                               3.6           2.5                50.6     

 

Q226            2.2 *            75.0                       -4.0                               3.3           2.7                51.7      

 

Q326            2.1 *            40.0                       -1.0                               3.1           2.5                52.4          

                                                                           

* Based on the Atlanta Fed Model's latest projection of 3.7% for Q226 (q/q, saar). 

 

Fed Policy and Latest Key Economic Data

 

Last week's softer-than-expected inflation and employment data lifted expectations of steady Fed policy at the October 27-28 FOMC Meeting, although these Reports should not have changed Fed views by much if at all.  The Reports still showed higher-than-desired inflation and a solid labor market.  Nonetheless, they provide reasons for the Fed to fall back on if it wants to avoid hiking rates just before the mid-term elections.  Indeed, recent comments by two top Fed officials -- the Fed Vice Chair and the NY Fed President -- suggest they are open to skipping a tightening in October, citing a need to wait and see more data.

 

Although the headline m/m prints for the August PCE Deflator were lower than expected, the underlying pace is still higher than the Fed's 2% target.  Along with the benchmark revisions to prior months, the 0.2% m/m increase in the Core PCE Deflator resulted in 3.0% y/y.  Moreover, the Core PCE Deflator was rounded down from 0.245%.  On an annualized basis, it was up 3.0%.  The annualized increase since December is 3.2%.  Note that the Core PCE Deflator has to average less than 0.22% m/m for the rest of the year to lower the y/y by December.  All these ways of evaluating underlying inflation should not dissuade the Fed from sticking with its hawkish tilt.  

 

Similarly, although September Nonfarm Payrolls rose only slightly, the weakness was probably not enough to convince the Fed to change its view of a solid labor market.  The Unemployment Rate remained within its recent tight range that is typically viewed as full employment.  The broadest unemployment measure of the labor market -- U-6- which takes account of part-time workers for economic reasons and people marginally attached to the labor force -- dipped.  And, Total Hours Worked are up 1.2% (q/q, saar) in Q326 -- a bit more than the 1.1% in Q226.  So, they are consistent with 2.0+% Real GDP Growth in Q326, taking account of productivity growth -- better than the Fed's longer-run growth estimate of 1.8-2.0%.  

The lower-than-consensus increase in September Payrolls ran counter to the speedup suggested by Unemployment Insurance Claims data.  The contradiction suggests that the slow job growth results from  weak hiring rather than increased firings.  This result appears to have been the case over July and August.  The JOLTS Data show that a 241k decline in Separations in the Private Sector over the 2 months (that is fewer layoffs) was partly offset by a 170k decline in Hiring.  This combination is unusual.  Typically, cyclical forces lead to increased hiring accompanying reduced firings.  AI may be holding back hiring?

The difficulty of finding a job (along with high gasoline prices) may be behind the recent decline in consumer confidence.  The Conference Board's measures of Jobs Hard To Get and Jobs Plentiful could provide clues whether job finding remains a problem or is beginning to improve.  

Higher Long-Term Treasury Yields

A possible Fed reluctance to tighten ahead of the mid-term elections in the face of still problematic inflation may be behind the latest run-up in longer-term Treasury yields.  The latter may be making up for Fed inaction to fight inflation.  Although a more aggressive Fed could bring longer-term yields down, it would hurt the economy and stocks.  The best development for both the Treasury and stock market (and economy) would be an ending of the Iran war than results in a drop in oil prices.  

Mixed Surprises in this Week's Key US Economic Data?

The stock market may find mixed surprises in this week's key US economic data.  In particular, the August PCE Deflator risks printing below consensus, while the September Employment Report may be on the stronger side.  Even if some data raise disappointing risks, such as a strong Employment Report, the market's downside could be limited ahead of expected strong corporate earnings reports in October.   

Consensus looks for a high August PCE Deflator (+0.4% m/m Total and +0.3% Core).  On a y/y basis, the Core is seen speeding up to 3.4% from 3.3% in July.  However, Fed Chair Warsh said in his post-FOMC news conference that Fed staff looked for the y/y to slip to 3.6% from 3.7% for Total and to fall to 3.2% for Core.  The latter implies +0.1% m/m.   So, the risk is that consensus is too high.   

A lower-than-consensus print could prompt relief in longer-term Treasury yields, but the Treasury market may remain concerned about a possibly strong September Employment Report at the end of the week.  Consensus, however, expects a calm Report.  Payrolls are seen slowing to +100k m/m from +162k in July, with the Nonfarm Workweek falling back a bit, and the Unemployment Rate edging up to 4.2% from 4.1%.  Private Payrolls are seen slowing to +85k from +127k.

To be sure, the market may view a consensus Payroll print as strong.  It would be above the prior 3-month average of +71k m/m and the +75k pace that is consistent with a steady Unemployment Rate if the Labor Force Participation Rate doesn't change.  A decline in the Nonfarm Workweek, however, would be an offset to the Payroll increase in terms of Total Hours Worked.  So, there would be less significance for economic growth if the consensus estimates are right.

The Unemployment Claims data point to a speedup in Private Nonfarm Payrolls, but they are not necessarily inconsistent with the consensus estimate.  This is because Private Payrolls were boosted by a 62k jump in Leisure and Hospitality jobs in August that made up the declines over June and July.   Ex this rebound, Private Payrolls rose only 65k in August.  This may be the more relevant comparison for evaluating the Claims data than the printed data.  So, a consensus print would be consistent with the implication of a speedup by the Claims data.

The Claims data also suggest a decline in the Unemployment Rate.  However, this may show up only in the unrounded Rate.  The latter was 4.14% in July.  It would need to fall by more than 0.09% pt to round to 4.0%.  Note, the Labor Force Participation Rate rose in July after having fallen over the prior 8 months (helping to increase the July unrounded Rate).  The uptick could have been a small sample effect of the Household Survey, and a reversal in September could work toward pushing the Unemployment Rate down.  A further increase in the Participation Rate would be good news for the economic growth outlook as it would signal the possibility of increased capacity to grow ahead.

An important part of the Report should be Average Hourly Earnings (AHE).  Consensus looks for a trend +0.3% m/m.  A trend print would show that the stronger labor market is not generating inflationary pressures.   It could take some steam out of the market's concern about the inflationary implications of stronger economic growth.

The Treasury market may focus on the September Mfg ISM as well as the Employment Report, inasmuch the market was spooked by the near-5 point jump in the Market US PMI Report last Thursday.  The consensus estimate of a small increase in the Mfg ISM to 54.8 from 54.6 in August may offer relief, even though it would be a new high for the move up.   

There is an irony to the surge in long-term Treasury yields.  The related increase in mortgage rates risks shifting housing demand away from home buying to renting.  Resultant higher rents will eventually feed into the CPI and PCE Deflator, boosting inflation.  So, an unwinding of the surge in longer-term yields, either because of weaker-than-expected economic data or because of good news from the Iran war, would be favorable for the inflation outlook and help dampen expectations of Fed tightening ahead.

 

 

Non-Economic Factors This Week, But...

The stock market should be dominated by non-economic factors this week -- Iran war developments,  tariff news, and the summit between Presidents Trump and Xi Jinping.  Nevertheless, last week's FOMC results had some market-supportive messages.

Among this week's non-economic factors, the Iran war is probably the most important.  Any change that results in a sharp decline in oil prices could help persuade the Fed and markets that inflation may have peaked.  In particular, the 10-year Treasury yield would likely fall below 5.0%.   

 

There was little that was new in Fed Chair Warsh’s post-FOMC news conference last week.  Regarding monetary policy, he said financial market conditions are not restrictive even after the 25 BP rate hike -- despite the economy being strong and inflation too high.  This keeps open the door for more rate hikes ahead, and the Fed's "dot" chart points to one or two more hikes this year.

 

Warsh cited the above-target 6- and 12-month moving averages of Total and Core PCE Deflator in stating that inflation is too high.  Note, however, that moving averages are backward-looking.  What may be more important is that the Fed's Central Tendency Forecasts call for inflation to move lower to 2.3-2.6% next year and then move even closer to target -- in the 2.0-2.2% range -- beginning in 2028.  Monetary policy, according to the Fed's forecasts, therefore is seen steady to softer during 2027-28.  The stock market should take some comfort in this policy outlook (at least until the data say otherwise), as it is not pointing to so much restriction to bring on a recession.  In addition, the potential for near-term rate hikes should continue to have downward influence on commodity prices and longer-term yields.

 

The markets could take a positive view of Fed policy after they see the August PCE Deflator.  The Fed staff forecasts low prints (due September 30).  The Total PCE Deflator is seen up 3.6% and Core 3.2% y/y.  These estimates imply low 0.2% m/m for Total and +0.1% m/m for Core.  To be sure, the Fed will probably have to see several months of similarly low prints to be persuaded that inflation is coming down significantly.  

 

Meanwhile, the Unemployment Claims data support Warsh's view that the labor market is strong.   Both Initial and Continuing Claims made new lows for the move down in the latest week.  At this point, they point to a speedup in September Private Payrolls.  The Atlanta Fed model's latest forecast is 5.1% (q/q, saar) for Q326 Real GDP Growth.  Real GDP rose 1.8% (annualized) over H126, in line with Fed's estimate of longer-run growth in the US.

 

 

 

 

Will Stocks Like A Rate Hike?

The stock market may react positively to a Fed rate hike at this week's FOMC Meeting, while reacting negatively if the Fed does not hike.   The markets raised their probability of a Fed rate hike after the high August Core CPI was released on Friday.  Are they right?  There continue to be mixed considerations.

Possible Stock Market Reaction 

Stocks may view a rate hike positively for several reasons.  /1/ With the Fed finally moving against inflation, longer-term Treasury yields could fall.  The short-end would be taking on some of the anti-inflation work.  /2/ Tighter policy now may reduce the extent of tightening needed later.  /3/ A tighter Fed could reduce the risk premium in commodity prices.  Lower commodity prices, particularly oil, should be a positive for stocks.  It also would work to lower longer-term yields.

In contrast, steady Fed policy could lift inflation expectations and prompt further increases in commodity prices and longer-term yields, both of which would be negative for stocks.  Also, the risk of Fed tightening after the mid-term elections would increase, possibly by more than if the Fed had moved sooner.   So, this risk would continue to weigh on stocks.  And, the markets could conclude that the Fed was bowing to pressure from the Administration, damaging its reputation of being politically independent.  

Arguments For/Against a Hike 

1. While the 0.3% m/m August Core CPI was on the high side, large increases in a couple of components -- Airfares and Lodging Away From Home -- were mainly responsible.  Higher fuel costs were likely behind the jump in Airfares for the second month in row.  Volatility appears to be behind the bounce in Lodging after the latter dropped in July.  The bulk of the Core components were benign.  The Cleveland Fed's measure of the median CPI and trimmed CPI both rose only 0.2% in August.  So, "fence sitter" FOMC members could decide to keep policy steady despite the high print, blaming it on a "bad" distribution of "noise" and higher oil prices this month.  However, they may vote to tighten in response to the stickiness of inflation.  

2.  A desire not to tighten ahead of the midterm elections could hold back the Fed, as well.   

3.  However, the Fed's credibility could be in question if it doesn't tighten, particularly since Warsh has emphasized the Fed's intent to bring down inflation.  He has said that steady but high inflation is not acceptable.  Although the y/y for the Core CPI slipped to 2.4% from 2.5%, it remains above the Fed's 2% target.  The uptick in the University of Michigan Survey's 5-year inflation expectations to 3.4% from 3.3%, reported Friday, could add to the concern that the Fed is losing credibility, as could the recent sharp increase in longer-term Treasury yields.  

4.  Another consideration, away from the latest inflation data, is that the reasons for the 2024-25 rate cuts no longer apply -- /1/ real rates are not higher because inflation fell and /2/ the labor market is not weakening, unlike what appeared to be the case then.  Arguably, reversing these cuts could be appropriate.  This reason would point to another rate hike later this year even if the Fed hiked this week.

5.  In addition, the US economy is being propelled by several independent forces -- AI build-out, defense spending and re-shoring of production.  Higher rates are needed to make room for them, given the economy is at full employment.  Indeed, as Fed officials like to point out, an AI-caused ratcheting up of productivity growth would require higher market yields.  Otherwise, there could be over-investment.