A Santa Claus Rally?

A Santa Claus rally in stocks this week cannot be ruled out.  There is little US economic data scheduled for release and stocks may have overreacted to fears of recession in the past two weeks.  

The Claims data offer reason to think the market overreacted.  Initial and Continuing Claims both stopped rising in the past two weeks, providing hope that the economic slowdown is not snowballing.  To be sure, the Claims data (as well as some other evidence) so far support the idea of a slowdown in December Payrolls and an increase in the Unemployment Rate.  But, these prints would be consistent with a slowdown, not a recession.

Besides Claims, the other US economic report of interest this week is the Chicago PM.  It has done a good job predicting the m/m direction of the Mfg ISM since April.  Consensus looks for an increase in Chicago.  Other survey data are mixed, but none has as good a tracking record as Chicago.

If the market pulls back its fear of a near-term recession, perhaps as a result of not-so-bad prints for the December Employment Report and Mfg ISM, a sustained rally will probably depend on Q422 corporate earnings.  Right now, consensus appears to be for a slight uptick on a y/y basis, despite a sequential q/q decline.  The macroeconomic evidence (see table below) shows some negatives -- slower growth here and abroad, as well as a still strong dollar and a slowdown in oil prices.  But, profit margins may still be supportive of earnings, as prices may have climbed faster than wages (on a y/y basis).  Earnings may have to exceed consensus for stocks to climb further.

The extent and duration of a stock market rally, however, would be constrained by the Fed's intent to keep economic growth slow enough to generate slack in the labor market.  The economy would likely respond positively to an easing of financial market conditions (which include higher stocks), contrary to the Fed's desire.  So, additional Fed restraint, by further rate hikes or through tough Fedspeak, would likely serve to undermine the rally.  Until labor market slack is sufficient, e.g., with the Unemployment Rate at or above 4.8% and wage inflation slowing, the potential for an aggressively restrictive Fed will hover over the stock market.  The end result may be a cycling stock market over next year or so, possibly within a broad range.

                                Macroeconomic Evidence Regarding Corporate Earnings

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

Q421            5.5                  82.4                +1.3                              4.6           5.0               58.2  

 

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                              4.5           6.0               47.1                                    

                                                                           

* Based on the Atlanta Fed Model's latest projection of 2.7% (q/q, saar). 

Recession Fears Now Dominate Stocks

The stock market did not take the Fed's message well last week, choosing to focus on the recession risks of tighter monetary policy and not on the Fed's flexibility to change policy quickly if needed -- the latter implied by the downshift to a 50 BP hike at the meeting.   Despite the Fed's intent to bring down inflation, the downshifting shows they are mindful of other considerations, as well.  At this point, the market appears to be bracing for recession.  Weak US economic data are a negative, while strong data will probably be discounted as temporary.

This one-minded reaction to soft economic data was seen in the sell-off on the decline in November Retail Sales.  The -0.6% m/m  Total and -0.2% Ex Auto, with small downward revisions to the prior two months, was treated as evidence of a weakening consumer.  But, a small decline after a large increase, as in October, is often the case.  Retail Sales are volatile and one month's change (and even 2 months') should not be treated as a trend.  

This week's US economic data for November are expected by consensus to be soft -- not good for stocks.  Housing data -- Starts, New and Existing Home Sales -- are seen falling  Total Durable Goods are expected to fall and Ex Transportation to slow.  Consumer Spending should slow.  Initial Claims are projected to rebound.  

Weak housing data should not be a surprise, as this has been the recent trend and their sensitivity to the tighter monetary policy is well known.  Weak manufacturing data, in contrast, may be more significant, as they would confirm the recent declines in the Mfg ISM and other surveys and show a broadening softening in the economy.  There already has been some confirmation.  Last week's report on November Industrial Production showed manufacturing down for the month -- consistent with Total Hours Worked data.  In particular, motor vehicle assemblies fell to its lowest level since March.  A weakening in manufacturing is continuing in December, according to early surveys.

While housing and manufacturing are feeling the effects of tighter monetary policy, they are not the entire economy.  Unemployment Claims are the broadest high-frequency data available.  They surprised to the stronger side in last week's report.  It will be of interest to see if the consensus expectation of a rebound in Initial Claims turns out correct.  A counter-consensus decline in Initial Claims would raise a question about whether weakness is in fact snowballing.   

The Atlanta Fed model's current forecast of 2.8% for Q422 Real GDP Growth presumably would be revised down if this week's US efconomic data print on the weak side.  The model forecast is well above the 1.3% implied by the Fed's Central Tendency Forecast for 2022 Real GDP.  

Despite the market's fears, a recession is no sure outcome.  Besides the Fed having downshifted (and possibly downshifting more in Q123), the huge FY23 federal spending budget should provide a boost to the economy next year.

 

 

A Relief Rally?

A relief rally by the stock market probably will require two developments: /1/ a November CPI near consensus and /2/ less-than-feared rate projections coming out of the December 13-14 FOMC Meeting.  If the markets get past these two events unscathed, then a window opens for a "Santa Claus" rally into year end if not longer.

Consensus looks for +0.3% m/m Total and Core CPI for November.  This expectation can't be dismissed, but there may be more upside than downside risk.  A consensus print would probably require /1/ Owners' Equivalent Rent coming in at +0.6% m/m, the same as in October, /2/ holiday discounting showing up in Apparel and other goods, and /3/ a further decline in Airfares.  Airline fares fell a large 5.0% m/m in the November PPI, but they are measured differently in the CPI.  Also, the decline in PPI Airfares could  be catch-up to the decline in CPI Airfares that occurred in October.

A downshift in Fed rate hikes to 50 BPs at this meeting is almost guaranteed.  This would raise the funds rate target to 4.25-4.5%.  The markets will likely focus on the endpoint projected for the funds rate in the "dot" chart and Central Tendency forecasts.  Endpoints of 5.0-7.0% have been mentioned by a few Fed officials in recent weeks.  An endpoint in the 5.5-6.0% range, implying 2-3 more 50 BP hikes, would probably be viewed favorably by the stock market.  The endpoint in the September Central Tendencies is 4.5-5.0%.

While news analyses focus on the risk of recession in analyzing the latest decline in the stock market, there is no sign as yet that one is imminent.  The Atlanta Fed model's forecast is back up to over 3.0% (q/q, saar) in Q422.  The labor market is slowing gradually, but it may be reflecting efficiency drives by companies rather than a weakening in demand for goods and services.

A continuation of solid economic growth can be attributed to several factors.  Fiscal policy is a positive.  In October, some state governments issued a large amount of tax rebates.  While they are one-time, they likely are helping to lift holiday spending.  Similarly, the stimulus-driven excess saving during the pandemic continues to be source of consumer purchasing power.  Defense restocking of armaments also may be helping some industries, as may be new incentives for investment in climate/energy projects.  Away from fiscal policy, the return of manufacturing activity from abroad is a positive, particularly if it entails large amounts of investment.

These factors are working against the Fed's goals of slowing the economy and pushing down inflation, raising the possibility that this week's endpoint forecasts may not be the last word on the subject.  But, there is time for the Fed to evaluate whether a further upward adjustment will be needed.  And, there are no signs yet of impending recession.  So, the markets might have a window in Q123 to worry less about Fed policy or an economic downturn.

November Employment Report and the Fed

The stock market could be constrained going into the December 13-14 FOMC Meeting, weighed down by fears that the stronger-than-expected November Employment Report will keep the Fed on an aggressive path.  But, the economy is slowing, which supports a less aggressive approach to policy tightening.  So, a downshift in rate hikes to 50 BPs from 75 BPs remains likely.  The economy is not slowing enough as yet, however, to ease labor market conditions sufficiently to hold down inflation on a sustained basis.  The endpoint of this tightening cycle will likely be raised as a result.

The problem with the November Employment Report was not so much that Payrolls came in stronger than expected but that wage inflation remained high.  Payrolls slowed in November relative to October, which was consistent with the implications of the Unemployment Claims data.  The latter and other evidence, including the decline in the November Average Workweek, at this point suggest Payrolls will slow further in December.  However, the November pace is still well above the desired 100k mentioned by Fed Chair Powell in his speech last week.  Moreover, Retail/Warehousing/Courier jobs fell, suggesting lower-than-normal holiday hiring that will reverse in January.

Other components of the Report also point to slower economic activity.  With the Average Workweek down last month, Total Hours Worked (THW) fell m/m.  THW look like they slowed to 0.9% (q/q, saar) in Q422 from  3.0% in Q322.  The Unemployment Rate also suggests some weakening in economic growth.  While the Unemployment Rate was steady at 3.7% in November, it remained slightly above the 3.6% Q322 average.   The Atlanta Fed model's estimate of Q422 Real GDP Growth is down to 2.8% from 4.3%.  But, even this pace may understate the degree of slowing in the economy.  The m/m trajectory of THW shows a slowdown over the course of Q422.  It enhances the possibility of slower GDP Growth in Q123.

The problem for the Fed and the markets is that wage inflation picked up in the past two months.  Average Hourly Earnings (AHE) rose 0.6% m/m in November after an upward-revised 0.5% in October (was 0.4%).  Both are above the prior 0.4% m/m trend.  The November increase was widespread, with 8 of the 13 major sectors speeding up.  Nevertheless, the overall November speedup could have resulted from the extraordinary jumps in Transportation/Warehousing and Information  (+2.5% and +1.6%, respectively).  A simple average of the AHE sectoral changes excluding these two yields +0.4% in November versus +0.5% in October.  Moreover, the Transportation/Warehousing AHE surge could reverse after the holidays.  So, there may be less than meets the eye in the large overall AHE increase in November.

In his speech last week, Fed Chair Powell cited the "uncertain lags" between monetary policy and growth and inflation.  And, wage/price inflation tends to lag policy more than does growth.  So, the combination of an economic slowdown with still high wage inflation is to be expected.  Powell also mentioned that excess demand for labor could be exerting upward pressure on wages.  And, the Fed is aiming to restore balance in the labor market.  These comments imply that economic activity has to slow even more than it already has, if not decline, to bring wage inflation under control.  The Unemployment Rate probably has to rise at least a percentage point to do so.

Nonetheless, the slowdown in economic growth, as seen in THW, should encourage the Fed's belief that the tightening to date is having an effect.  So, officials could feel comfortable downshifting rate hikes to 50 BPs from 75 BPs.  At the same time, the failure of wage inflation to respond as yet argues for the Fed to raise its expected terminal point, pointing to more rate hikes next year than it had penciled in at the September FOMC Meeting.

Looking ahead to the November CPI, due December 13, a relatively moderate but still above-Fed target print is a good possibility.  A slight speedup in the Core CPI from October's +0.3% m/m can't be ruled out.  Among the components, Used Car Prices and Medical Care Services are not likely to subtract as they did in October.  And, Owners' Equivalent Rent may not slow again: while the lagged effect of the rent slowdown should continue to pull it down, there could be a smaller subtraction from the energy adjustment in its calculation this month.  Food Away from Home and Lodging may continue to be lifted by higher wages.  AHE in the Retail and Lodging sectors sped up in both October and November.

 

Some Favorable Evidence This Week?

The stock market is likely to sustain the rally this week, albeit cautiously, as expectations for key US economic data support the Fed's inclination to downshift rate hikes at the December 13-14 FOMC Meeting.  But, they leave open the door for an upward revision in the fund rate's endpoint.  Most evidence -- but not all -- supports the m/m direction of the consensus estimates, suggesting stocks will retain an upward bias but cautiously. 

This week's data, themselves, may not affect the Fed's Central Tendency forecasts or "dot" chart to be updated at this meeting.  This is because the District Bank Presidents probably will have submitted their forecasts before the data are released.  The data, nonetheless, will be important by influencing market expectations of future Fed policy.

Consensus looks for a softer November Employment Report.  Payrolls are seen slowing to +208k from +261k in October,  the Unemployment rising 0.1% pt to 3.8%, and Average Hourly Earnings (AHE) slowing to +0.3% m/m from +0.4%.  The AHE trend so far this year is +0.4%.   A near-consensus Employment Report would argue for a downshift in rate hikes, but also for further hikes in H123.  Payrolls would need to slow further and the Unemployment Rate higher to establish the labor market conditions that would sustain low inflation.

Most of the evidence supports a slowdown in Payrolls and an increase in the Unemployment Rate.  The Claims data support these ideas after the latest report showed another jump in Continuing Claims.  Also, less-than-normal holiday hiring could depress Retail Jobs.  But, Warehouse/Trucking/Courier jobs could bounce, as holiday shopping may have shifted to on-line from brick and mortar sources.  The composition of October Retail Sales suggests this could be the case, as does the latest news reports.  If holiday-related payroll effects show up in the data, however, they should be discounted.  This is because their reversals in January are likely as the post-holiday unwindings don't meet seasonal expectations.  Retail Jobs should bounce and Warehouse/Trucking/Courier jobs drop in January.  So, weak Retail Jobs or strong Warehouse/Trucking/Courier jobs in November should be discounted.  

The consensus estimate of a decline in Job Openings to 10.3 Mn in October from 10.7 Mn in September fits with the view of a softening labor market.   But, this estimate is still well above the pre-pandemic 7.0 Mn level.  So, the near-consensus print would show excess demand for labor continuing.

Consensus also expects a modest October PCE Deflator, with the Core up 0.3% m/m after +0.5% in September.  This is old news, however, as it largely reflects the slowdown already seen in the CPI.  The risks are mixed from the the technical differences between the two.  The PCE Deflator assigns a smaller weight to Owners' Equivalent Rent, which pushes down the Deflator relative to the CPI.  But, Health Services and Airfares are measured differently in the two measures, and they could add to the Deflator rather than subtract as they did in the CPI.

Consensus sees a decline in the Mfg ISM to 49.8 in November from from 50.2 in October, as most manufacturing surveys fell so far this month.  Note, however, that consensus also expects an increase in the November Chicago PM, and that survey has done the best job predicting the direction of the Mfg ISM in recent months.  A decline in Suppliers' Delivery could be a contributing factor to a fall in the Mfg ISM.  But, a lower Suppliers' Delivery would not indicate weak manufacturing.  Instead, it would suggest that supply constraints are easing -- good for economic growth and fighting inflation.  An easing in supply problems and lessened price pressures were cited in the Markit European PMIs.  An easing also was suggested by evidence from the Industrial Production Report, which shows motor vehicle production having continued to climb in October.

The November FOMC Minutes confirmed that the inclination of a number of Participants is to downshift rate hikes "soon."  But, they also showed that a number raised their expectation of the endpoint of the tightening cycle.   Revised Central Tendencies will be released at the December FOMC Meeting.  So, the stock market is not out of the woods yet with regard to near-term monetary policy developments.

 

Problem for Stocks: Macro Fundamentals Moving in Right Direction, But More Needed

The stock market should continue to trade cautiously this week, even though stocks tend to rise in the Thanksgiving week.  The focus is on Fed policy, and key US economic data are not due for another week.  

The macroeconomic fundamentals are moving in a favorable direction for the Fed, but officials' recent comments suggest they have not moved enough.  So, while a downshift to a 50 BP hike at the December 13-14 FOMC meeting appears to be the prevalent opinion, some officials have continued to highlight the possible need to raise the endpoint of the funds rate in this tightening episode.  This possibility will likely be mentioned in the November FOMC Minutes, released this week.  Endpoints of 5.0-7.0% have been mentioned. 

The Labor Market is one area that is moving in the right direction but has a long way to go.  Payrolls have slowed and the Unemployment has risen.  But, Fed officials would probably like to see the Rate move up a percentage point above its latest 3.7% level.  This would require a much more substantial slowdown in job growth, possibly to below 100k m/m.  Also, while Job Openings fell sharply in September, they were still well above pre-pandemic levels.  They need to fall another 3 Mn to get there.   Fed officials view the overage as a measure of excess labor demand.  

The Claims data so far don't suggest a significant further softening in the labor market, but one more week's data are needed for a complete picture.  The 4-week average of Initial Claims is only slightly higher than it was going into the October Payroll Survey Week-- 219k versus 212k.  It suggests a modest increase in layoffs this month, despite recent headlines.  Continuing Claims so far are higher than in the October Survey Week, suggesting hiring has slowed. But the increase still hasn't matched the increase between the September and October Survey Weeks.   Another week's data are needed to see if this changes.  The Insured Unemployment Rate so far remains at 1.0%, suggesting little change in the Civilian Unemployment Rate.  

The layoffs that have happened so far appear to have more to do with improving efficiency than adjusting to lower demand for products.  The Atlanta Fed model's latest estimate of Q422 Real GDP Growth is 4.2% (q/q, saar).  If correct, the strong output growth would likely translate into a bounce in Productivity.  This would be a good development for the fight against inflation.  But, such a high GDP growth rate would be a concern to the Fed, particularly if this pace is seen persisting into 2023.  An overheating economy, not recession, would become their chief worry.  It could lead to a return to 75 BP hikes.

Stock Rally To Continue For Now

The stock market should extend its post-midterms rally, possibly through the rest of the year, thanks to three developments suggested in part by last week's data: /1/ inflation may have peaked, /2/ labor market is softening, and /3/ a divided government remains a possibility.  The first two point to a downshift in Fed tightening to 50 BP hikes and possibly a not-so-large increase in the expected end-point.  The third point suggests the possibility of actions to reduce the Federal deficit.

The 0.3% m/m increase in the October CPI reflected slowdowns in a number of components that fundamentals suggest may persist.  New Vehicle Prices finally may be beginning to react to an easing in production disruptions.  Increased vehicle supply has been evident in Industrial Production data, and could be seen to have continued in October in this week's IP report.  The decline in Used Car Prices also reflects this improved demand/supply situation.  And, the CPI's measure of housing rent finally may have begun to pick up the declines seen in recent surveys.  But, declines in other components, like airfares and medical services, may be one-off.  So, while the October CPI is encouraging regarding a peaking in inflation, the problem may not be resolved satisfactorily as yet.   

The Claims data show a modest softening in labor market conditions.  Both Initial and Continuing Claims are moving up from their September lows.  In particular, the jump in Continuing in the latest week suggests that hiring has slowed.  A couple of more weeks of data are needed to determine whether they point to a slowdown in November Payrolls.  A sustained pickup in economic growth without re-triggering inflation requires substantially more slack in the labor market.

Republican control of the House has not been resolved yet, although control remains a possibility at this point.  Such a result could be positive for the stock and Treasury markets, particularly if it pushes the Administration to work with Republicans to pass legislation reducing the Federal deficit.  Even an announced intention to do so would likely lower the medium- and long-term Treasury yields -- a positive for stocks.  Note that anti-deficit talk from the Clinton administration had these market effects in the 1990s.

These developments are likely to persuade the Fed to downshift to 50 BP rate hikes at the December FOMC Meeting, as suggested by recent Fed officials' comments.  They also could hold down upward revisions to end-point estimates of the funds rate in the Fed's Central Tendency forecasts.  But, the market moves -- higher stocks, stable to lower Treasury yields, and lower dollar -- could lead to a renewed speedup in economic growth and inflation that could put more aggressive Fed tightening back on the table at some point.  So, what we may be going through is a cycle rather than a straight uptrend in the economy and markets.

What's Important -- Speed or Endpoint of Fed Tightening? A Different View of Wage Inflation

The stock market faces the midterm elections and October CPI this week.  Historically, stocks tend to rally after these elections.  But, this week's CPI release is expected to show that inflation remains a problem.  Along with fears of an upward-revised 2023 endpoint for Fed tightening at the December 13-14 FOMC Meeting, the stock market may have trouble following the historical pattern this year.  To be sure, a below-consensus CPI can't be ruled out, in which case the seasonal pattern could persist for awhile.

The stock market is now focused on the endpoint as well as the speed of Fed tightening, after Fed Chair Powell emphasized the former.  The speed, however, still could be more important from the stocks' perspective at this point.  A slower speed reduces the risk of a market or financial crisis (such as what happened in the UK).  It also reduces the risk the Fed will overshoot tightening and precipitate a recession. The endpoint is far down the road and could change.

A potential problem, however, is that a gradual pace of tightening may not be enough to achieve the Fed's goal of lower inflation.  This was the case in 1994, when Greenspan tried to slow the economy with a string of 25 BP hikes.  The economy slowed only after he shifted to larger hikes.  Ironically, a slower pace of hiking could result in a higher-than-otherwise endpoint.

The Fed's shift to emphasizing the endpoint as well as the speed of tightening feels like a compromise between FOMC members who are focused on eliminating inflation at any expense (eg, Powell) and those who are concerned about fall-out from continuing sharp rate hikes (eg, Brainard).  Powell suggested the year-end endpoint for 2023 will be raised from September's 4.4-4.9% in the revised Central Tendency forecasts at the December 13-14 FOMC Meeting.  Some economists, like Larry Summers, thinks it should be at least 6.0%.   

A silver lining of an endpoint forecast is that it is not written in stone -- as evidenced by the continuing revisions to the Fed's Central Tendencies.  December 2023 is a long way off, and many things could happen along the way to undermine the forecast.  So, while the markets will adjust to the new forecast, they will likely do so with some tentativeness.  Indeed, the funds rate may never reach the forecast if Powell's hawkish rhetoric directly impacts economic decision making and activity. 

Although the Fed is focused on wage inflation as a culprit behind the high price inflation, this may not be the main problem boosting labor costs (see table below).  Compensation/Hour -- the broadest measure of labor costs per worker -- is already settling back to the range seen before the pandemic (3.5% so far in 2022 versus 2.0-4.3%, avg 3.1%, over 2015-2019).  The real problem is the weak Productivity Growth (-3.2% so far in 2022).  It was responsible for the jump in 2022 Unit Labor Costs.

Labor hoarding by companies may be responsible for the decline in Productivity -- despite all the talk of labor shortages.  Companies have too many employees for current production levels.  If so, companies' efficiency drives, as seen in a recent pickup in hiring freezes and firings, could solve the productivity problem by eliminating excess labor per unit of output.  It also could help cut price inflation if companies had passed on the costs of holding excess labor.  This could be the main way prices are held down rather than by slowing wage rate increases.  The latter remains a problem, as seen in  the 0.4% m/m increase in October Average Hourly Earnings.  It  kept them on the trend, albeit too high, seen since the start of the year. 

This understanding of the labor cost/price inflation nexus suggests that a pass-through of higher aggregate labor costs has played an important role in explaining the surge in inflation, not just the speedup in hourly wage rates.  It implies that the trade-off between Unemployment Rate and Wage Inflation (the Phillips Curve) may be less significant in the battle against price inflation than most think.  Instead, a decline in headcount at companies could directly hold back price inflation.  Conceivably, this channel could result in a faster decline in inflation than many expect.

A speedup in productivity in Q422 is suggested by the October Employment Report.  Although Payrolls were strong, Total Hours Worked only edged up and are 1.1% (annualized) above the Q322 average.   Similar m/m gains in November and December would put the Q422 average about a percentage point below the Q322 pace.  Meanwhile, the Atlanta Fed model's early estimate is for a speedup in Q422 GDP Growth.

Labor costs are not the only factor boosting price inflation.  Housing rent is another.  It has begun to fall, but at most should slow a bit in the October CPI because of the way it is calculated.  Even so, it would take some softening in other components for a sub-consensus print.  Airfares are a big uncertainty, however.  Otherwise, the consensus estimates of +0.7% m/m for Total and +0.5% for Core seem reasonable.  The most important component could be Core less Shelter, as it would show whether the underlying inflation excluding rent is slowing.  So far it has not.  It was steady at +0.5% in September, staying at the 0.5% m/m average seen since January.

                                                 (Q4/Q4 Percent change)

            Compensation/Hour        Productivity     ULC                   Core CPI

2015            2.6                             0.8                      1.8                          2.0        

2016            2.0                             1.3                      0.6                          2.2   

2017            4.3                             1.4                      2.9                          1.8

2018            2.6                             0. 9                     1.6                          2.2            

2019            4.2                             2.6                      1.5                          2.3    

2020             9.9                            4.7                      4.5                          1.6   

2021             5.3                            1.9                      3.2                          5.0                        

2022 *            3.5                           -3.2                    7.0                          6.5

Q322 **        3.8                            0.3                      3.5                          6.4  

 ULC = Unit Labor Costs = Compensation/Output (essentially equal to the percent change in Compensation less percentage change in Productivity)

* annualized change over first 3 quarters of 2022

**  q/q saar

This Week's FOMC Meeting -- A Short-Lived Disappointment?

The stock market may be disappointed by the outcome of this week's FOMC Meeting.  But, the disappointment could be short-lived.  After rallying on the belief that the Fed will downshift rate hikes after this week's 75 BP hike, stocks could pull back somewhat if the Statement and Fed Chair Powell do not say so explicitly but emphasize data dependency in discussing future tightening.  Although this emphasis would keep open the door for a downshifting at the December FOMC Meeting, it is no guarantee.  It could depend on whether US economic data released up to the December meeting show lower inflation or weaker economic growth. 

The Fed could stick with its data dependency approach to tightening because so far there is little evidence that it is achieving its goals.  Economic growth picked up in Q322 and core inflation remained high.  Without evidence of success, the bond market could sell off if the Fed downshifts -- viewing it as premature.  

This week's October Employment Report (due Friday) and September JOLTS data (Tuesday), however, could fit the bill and keep alive the market's belief in a December downshift -- and thereby sustain the rally.  Consensus expects the October Employment Report to show a Payroll slowdown, an uptick in the Unemployment Rate and a modest increase in Average Hourly Earnings.

The Claims data support a forecast of a smaller Payroll in October than September's +263k m/m,  Consensus expects +220k.  Anecdotal evidence also suggests some jobs softness.  News reports indicate that retailers may hire fewer-than-normal holiday workers this year.  Retail job weakness may show up more in November and December than in October, however.  A Payroll slowdown would be in the right direction from the Fed's perspective, but a slowdown to +100k or less would be needed to clearly indicate a softening in labor market conditions.  

The consensus expectation of a 3.6% Unemployment Rate, up a bit from September's 3.5%, also does not suggest a significant easing in labor market conditions.  The uptick could be just noise.  The Rate needs to rise to 3.8-3.9% by year end to meet the Fed's expectation seen in its Central Tendency Forecasts.  

Possibly the most market-positive part of the Report would be a modest 0.3% m/m in Average Hourly Earnings, as consensus expects.  It would offer hope that labor costs are trending down.

The September JOLTS data also could provide encouraging evidence that the labor market is cooling.  A drop in Job Openings to sub-10 Mn from 10.05 Mn in August would indicate that excess demand for labor is winding down.  To be sure, Job Openings were in the 7 Mn range prior to the pandemic.  So, excess labor demand is likely to remain a problem for the Fed at this point.

In contrast to these softer Reports, the risk is for a counter-consensus increase in the October Mfg ISM (Tuesday), based on some regional manufacturing surveys.  Consensus looks for a dip to 50.0 from 50.9 in September.  The manufacturing sector is mixed.  The motor vehicle industry is escaping from the shortage problem.  Although some analysts raise concern about the impact of higher borrowing costs on vehicle sales, there is probably pent-up demand that needs to be satisfied.  Airlines, too, appear to be placing orders for additional planes now that air travel has bounced back.  Increased defense spending and a shift to "on-shore" production also are positives.   But, construction-/housing-related manufacturing likely is facing difficulties. An increase in the Mfg ISM could help persuade the Fed to stick to data dependency in talking about future tightening.

Will Bonds Let Stocks Break To The Upside?

The stock market may continue to be buoyed by the possibility of Fed downshifting after the November 1-2 FOMC Meeting -- a possibility highlighted by Friday's WSJ article.  But, a stock market bounce could be short-lived if longer-term Treasury yields jump as a result.  

Such reaction by yields is conceivable.  The Treasury market could be concerned that monetary policy downshifting is premature.  If the market is not persuaded that economic growth and inflation will slow, the yield curve could steepen.  This would be a problem for stocks.  With the Fed relying on tighter financial market conditions to bring inflation under control, bond yields have tended to jump when stocks bounce in response to a positive fundamental factor, like profits, or to holding technical support.  The higher yields have undermined the stock market's move, forcing it back to supporting the Fed's goal.  This "vigilante" role of the bond market could prevent stocks from reacting positively to a hint of future downshifting by the Fed at the November 1-2 FOMC Meeting.

To be sure, there are secondary effects of a policy downshifting that could help hold down longer-term Treasury yields.  A consequential reduction in the volatility of short-term rates as well as of dollar exchange rates should flatten the curve, according to some models.   

Evidence that the Fed is achieving its goals (lower wage/price inflation and softer labor market) may be what's needed to prevent a run-up in longer-term yields.  With the Fed succeeding, financial markets would not have to "work" as hard to support the Fed.   So the Treasury market could be comfortable with stocks breaking to the upside.

In this light, the Q322 Employment Cost Index (ECI) could be the most important US economic data to be released this week.  It is a broad measure of labor cost inflation and little affected by compositional shifts.  Consensus looks for the ECI to rise +1.3% q/q, the same as in Q222.   This estimate may be somewhat high.  /1/ While Average Hourly Earnings (AHE) sped up a bit in Q322, it remained below 1.3% (see table below).  But, AHE is a narrower measure of labor costs than the ECI, not covering many types of workers nor types of compensation, such as bonus payments.  As a result, the two can diverge considerably in a quarter, as was the case in Q421.  /2/ Away from AHE, a reduction in sales commissions, such as for realtors, could hold down the Q322ECI.

A below-consensus print for the ECI probably would be positive for the markets, but a print of 1.0% or higher still could be problematic for the Fed.  It would be well above the 0.6--0.7% trend prior to the pandemic.  A sub-1.0% print may be needed to satisfy the Fed and to truly lift stocks.

                         (q/q percent change)

            Avg Hourly Earnings        ECI

Q321              1.3                          1.2                                                

Q4                  1.5                          1.0                                               

Q1                  1.2                          1.4                                           

Q2                  1.1                          1.3

Q3                  1.2                          na

 

Stocks Not Out of Woods Re Fed

The stock market is not out of the woods with regard to the Fed after last week's key events.  The September FOMC Minutes and Fed Vice Chair Brainard's speech underscored officials' intent to bring down inflation, but they appear to plan sticking with the measured pace of tightening seen in the Fed's Central Tendency forecasts.  The high September CPI should not derail their adherence to this plan at the November 1-2 FOMC Meeting.  But, a slowdown in underlying inflation by early next year could be critical to their continued adherence.

The high 0.6% m/m September Core CPI underscored the stickiness of underlying inflation.  While the largest component, Shelter (includes Owner's Equivalent Rent) is largely backward looking and still moving up as a result of past increases, the Core Excluding Shelter rose +0.5% m/m in each of the past two months.  Although this pace is slightly less than the 0.6% m/m average over H122, it needs to slow to 0.2% or lower to get to the Fed's 2% target.

The real-side of the economy may not be slowing enough to knock down inflation. Ex Auto/Ex Gasoline Retail Sales slowed to +0.3% m/m in September from +0.6% in August.  The slowdown could be just the typical follow-through after a strong month, however.  The Atlanta Fed model's estimate of Q322 Real GDP only edged down to 2.8% (q/q, saar) from 2.9% as a result of the Retail Sales data.  Regarding the labor market, Initial Unemployment Insurance Claims have moved up a bit so far in October, but they remain below August levels.  Demand for labor remains strong.

One favorable feature of the current economic situation is that longer-term inflation expectations have been well contained -- which should mollify Fed officials to some extent and argue against the need to tighten more aggressively than what is embodied in the Central Tendencies.  The University of Michigan Consumer Sentiment Survey's 5-year inflation expectations rebounded to 2.9% in Mid-October from a low 2.7% in September.  The level is still low.  It has been in a 2.7-2.9% range since July, after a 3.0-3.1% range in H122. 

Fed Vice Chair Brainard, in her speech, acknowledged the contained longer-run inflation expectations.  And, she pointed out some evidence suggesting a re-balancing of the labor market.  Regarding monetary policy, she said it will take time for the cumulative effect of higher rates to bring inflation down.  This view suggests the Fed will not be derailed from its deliberate path of tightening because of currently high inflation prints. But, at some point, a continuation of high inflation data could prompt a more aggressive tightening path than now penciled in. 

She ended her speech with, "In light of elevated global economic and financial uncertainty, moving forward deliberately and in a data-dependent manner will enable us to learn how economic activity, employment, and inflation are adjusting to cumulative tightening in order to inform our assessments of the path of the policy rate."  The issue will probably become more critical early next year, when there will have been more time to see the effects of the recent tightening.   A further slowdown in underlying inflation would need to be seen by then.

 

 

 

Risks to the September CPI and Q322 Corporate Earnings

The stock market will likely be held down this week by fears of the September CPI (due Thursday), September FOMC Minutes, and upcoming Q322 corporate earnings.  But, the risks are that the consensus estimate of the CPI is too high and corporate earnings may be better than expected.  

Consensus looks for +0.2% m/m Total and +0.5% Core CPI in September.  But, some components may surprise to the downside.  Airfares could fall sharply, after not falling as much as anecdotal evidence suggested in August.  Also, some survey data suggest the CPI's measures of housing rent could slip.  High inventories, lower oil prices, and the strong dollar could exert downward pressure on a number of items, as well.

Consensus looks for a sharp slowdown in Corporate Earnings to 3.1% (y/y) in Q322 from the big gains in the prior two quarters (9.6% and 11.6%, respectively).   The macro evidence supports the idea of a slowdown (see table below).  But, not all evidence is negative, so earnings may surprise to the upside.    Profits from oil should weaken, as oil prices fell.  A strong dollar and slower economic activity outside of the US should hurt earnings from abroad.   But,  US economic growth looks like it could have sped up on a y/y basis.  And, profit margins may have held up -- besides prices having risen by more than wages, prices sped up while wages slowed.

The September Employment Report was not as bad regarding Fed policy as the markets made it out to be.  While the decline in the Unemployment Rate to 3.5% shows the labor market remained tight, wage inflation was subdued.  It raised the possibility that the Unemployment Rate might not have to rise as much as thought to hold down wage inflation.  The Q322 Employment Cost Index (due October 28) conceivably could provide some confirmation.  And, while the +263k m/m increase in Nonfarm Payrolls was well above the +100k pace needed to keep the Unemployment Rate steady, their slowdown was in the right direction.  The latest Unemployment Insurance Claims suggest a further slowdown in October.

At this point, a 75 BP hike at the November 1-2 FOMC Meeting seems to be a near-certainty, but the evidence does not guarantee Powell's threat of more aggressive tightening beyond the FOMC Central Tendency forecast of measured hikes terminating at 4.6% in 2023.   The September FOMC Minutes will probably emphasize this forecast.

A lot of news commentary is citing the still high 5% y/y increase in Average Hourly Earnings to argue that inflation is not falling fast enough. But, this is a backward looking way to measure wage inflation. The m/m change, +0.3% in both August and Sept, is a more current measure. The 0.3% pace (3.7% annualized), in fact, is consistent with the Fed's 2% inflation target once productivity is taken into account.

                                Macroeconomic Evidence Regarding Corporate Earnings

                                                                                                                                           Markit
                                                                                                                                          Eurozone                        Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    PMI  
                [                                y/y percent change                                                   ]    (level)
Q119            3.2                -12.8                 +7.9                             3.2           2.1               51.9 
Q219            2.7                -12.2                 +5.9                             3.1           2.1               47.8    
Q319            2.1                -19.2                 +3.6                             3.2           2.3               46.4
Q419            2.4                  -3.6                 +1.7                             3.2           2.3               46.2

Q120           -5.0                -16.5                 +2.9                             3.1           2.3               47.2

Q220         -10.6                -53.5                 +5.9                             6.5           1.4               40.1

Q320           -2.8                -27.8                 +1.0                             4.8           1.7               52.4

Q420           -2.4                -25.5                  -1.9                             4.8           1.6               54.6

 

Q121            0.4                  26.3                 -4.4                              4.9           1.4               58.3   

Q221          12.2                  32.1                 -8.3                              1.2           3.4               63.1 

Q321            4.9                  72.7                 -3.4                              4.2           4.1               60.9

Q421            5.5                  82.4                +1.3                              4.6           5.0               58.2  

 

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                  34.7                +9.0                              5.1           6.3               49.3

                                                                           

* Based on the Atlanta Fed Model's latest projection of 2.9% (q/q, saar). 

 

 

Markets Hoping for Calming Evidence, But...

The stock market hopes to see evidence that would lower the risk of Powell's threat to tighten beyond what was projected in the FOMC Central Tendencies.  Last Wednesday's bounce showed the sensitivity of the markets to official actions or hints to that effect.  The reversal of Wednesday's market moves, however, showed that evidence of a more concerted downshift in Fed views is needed to support the hope that Fed tightening will be "contained."  It is probably too soon to see a more general relaxation in Fed views, particularly since this week's key US economic data may not be weak enough. 

The most important report is the September Employment Report.  There is either mixed or no evidence regarding the risks surrounding the mostly benign consensus estimates.

    a.  Consensus looks for a slowdown in Payrolls to +250k m/m from +315k in August.  The slowdown would be welcome, but the magnitude of the gain is still too high.  Job growth needs to be closer to +100k to be in line with population growth, unless Labor Force Participation rises.  The evidence is mixed.  The Claims data do not suggest a slowdown.  There is still a possibility, however, that Payrolls could catch up to the smaller job gains indicated by the ADP Estimate during the summer.  

     b.  Consensus looks for a steady 3.7% Unemployment Rate, which is consistent with the Claims data.  An increase may be what's needed for the markets to feel the Fed is getting closer to meeting its goals.  The currently low Unemployment Rate is a sign that the problem facing the Fed is that the level -- not the pace -- of economic activity is too high.  

     c.  Consensus expects +0.3% m/m for Average Hourly Earnings, the same increase as in August and a "good" number regarding the Fed's desire to see wage inflation moderate.  There is no evidence to indicate the risks to the consensus estimate.  However, the low August print may have been just an offset to the high 0.5% July print.  If so, September could revert to the 0.4% trend.

Some of the disparate evidence could be reconciled if many companies are freezing hiring and letting natural attrition reduce job count.  If this is the channel through which the labor market eases, it could show up in /1/ slower job growth, /2/ no effect on Unemployment Insurance Claims,  /3/ little change in the Unemployment Rate, and /4/ lower wage inflation as higher-paid workers retire.  At the same time, companies could maintain listings of Job Openings but without intention to fill them soon.  While there have been news of some large companies freezing hiring, it is not clear how extensive this is.

Another important report this week will be the August JOLTS data.  The Fed sees excess demand for labor in the high levels of Job Openings and Quits.  At 11.2 Mn in July, Job Openings remain close to the pandemic peak of 11.4 Mn.  They were around 7.0 Mn prior to the pandemic, suggesting excess demand of 3.2 Mn jobs.  At 4.1 Quits in July, they are not far below the 4.5 Mn pandemic peak and well above the 3.5 Mn pre-pandemic levels.   A lot of people presumably are changing jobs for higher pay -- not good if the goal is to reduce wage inflation.

Consensus expects a decline in the September Mfg ISM to 52.3 from 52.8 in August.  The evidence is mixed.  But, the most accurate in recent months has been the Chicago PM, and it predicts a decline.  The fundamentals behind the manufacturing sector are mixed.  Defense-related industries are being helped by a restocking of guns and ammunition.  Motor Vehicle production is slowly recovering from supply constraints.  And, recent legislation boosted new infrastructure spending and encouraged a shift of production from China to the US.  But, the stronger dollar is making imports more competitive, allowing them to expand market share, while also making exports less competitive abroad.  Any expansion of the manufacturing sector would put upward pressure on interest rates, crowding out other economic activity, given the Fed's goal to weaken the economy.

Fears that the markets were in the process of overshooting may have been behind the Bank of England's bond buying and the calming comments by a couple of Fed Bank Presidents last Wednesday.  Philadelphia Fed Bostick and SF Fed President Daly asserted that the Fed is not aiming for recession.  Daly's comment is significant because she had dismissed concern about the labor market earlier this year.  It remains to be seen whether these comments were isolated or the start of a more concerted effort by officials to calm the markets.  At this point, other Fed officials' comments appear to adhere to Powell's hawkish stance, which may help explain why the stock market fell back on Thursday and Friday.  A number of Fed Bank Presidents will give speeches this week.

 

The Fed's Negative Message for the Markets

The stock market remains at risk for further declines.  Last week's market's plunge was likely exacerbated by a disconnect between Fed Chair Powell's hawkish anti-inflation message and the more measured forecasts contained in the FOMC Central Tendencies.  Powell was firm in leaving open the possibility that the Central Tendencies understate the extent of Fed tightening ahead.  To be sure, an understatement probably becomes relevant as a risk for the December FOMC Meeting on.  This is because a 75 BP hike at the November FOMC Meeting, consistent with the Central Tendencies, is probably a given.  Whether the market gets some relief in October, ahead of the November Meeting, could depend on the September Employment and CPI Reports surprising on the weak side.

Fed Chair Powell's said the Fed will not stop tightening until there is significant evidence that inflation is moving down to the 2% target.  Although he thinks the moderate pace of further tightening contained in the Fed's Central Tendencies is a reasonable expectation, it does not stand in the way for the Fed to tighten more aggressively if needed.  Policy will "evolve" as data come in.  In other words, take the Central Tendencies for what they're worth -- just forecasts -- and don't rule out additional tightening to what is built into them.  The Fed is adamant to make sure inflation will no longer be a problem.

He says financial markets are an important channel through which monetary policy will work to slow the economy and thus lower inflation.  Stocks have to fall, yields rise and dollar strengthen.  With Powell's stern warning in mind, financial markets may overshoot -- moving more than what will be necessary to achieve the Fed's goal.  Markets don't know how much tightening of financial conditions is needed to lower inflation -- and evidence becomes available with a lag.  The restrictive market moves may not end until significant evidence of a weaker labor market and lower inflation shows up.  This evidence would put a lid on Fed tightening. 

The Fed's Central Tendency forecasts are not as dire for the markets as Powell's warnings.  Most FOMC participants expect the Fed funds rate to end the year in the 4.0-4.5% area, suggesting some downshifting over the next two FOMC Meetngs after the funds rate was hiked to 3.25% last week -- most likely in December as another 75 BP hike in November makes sense for reasons I discussed last week.  The rate is seen being hiked just another 50 BPs in 2023, peaking at 4.6%.  Last week's Treasury market sell-off brought yields closer in line with the Central Tendency forecasts.  So, the worst may be over for now, but a relaxation of the sell-off may not last for long.

To put the 4.6% funds rate end-point in perspective, it is on the low side compared to past peaks (5.3-19.9%) that were followed by recession.  But, there are several reasons why it may be as powerful as rate hikes prior to past recessions.  /1/ The 4-1/2 percentage point increase from the trough in March is on the high side of the range of rate increases seen prior to recent recessions and /2/ has happened faster than in the past.  For example, it rose about 4 percentage points to 5.3% prior to the Great Recession of 2008, but it happened over 2-1/2 years.  Generally, it is not clear whether the level of the funds rate or extent/speed of increase in the funds rate is more important regarding economic growth.  /3/ The increase in the funds rate is being accompanied by reductions in the Fed's balance sheet, which could exacerbate the tightening at the long end of the Treasury yield curve.  

The other Central Tendency forecasts are fairly benign from a market perspective.  The FOMC expects below-trend economic growth in 2022 and 2023 -- not recession.  The Unemployment Rate is expected to climb modestly, peaking at 4.5%, and inflation to slow sharply over the next two years.

Specifically, Powell said the Fed wants to see /1/ higher Unemployment, /2/ a drop in Job Openings and Quits, /3/ a slowdown in wage inflation, and /4/ a slowdown in price inflation.  Unemployment Insurance Claims are the highest frequency data to watch regarding the labor market.  The latest data run counter to what the Fed wants to see.  Both Initial and Continuing Claims remain in a downtrend that began in mid-August.  Unless they begin to move up sharply, they will argue for more rate hikes.

 

Focus on the Fed

The stock market will likely continue to contend with the possibility of further aggressive Fed tightening past the September 20-21 FOMC Meeting, after the unexpectedly high August CPI dashed hopes for a downshift in tightening at subsequent meetings.  But, it is conceivable that last week's pullback may have largely built in another two 75 BP hikes.  The 4.0% 1-Year Treasury Bill yield suggests this is the case on the fixed-income side, as it reflects an additional 150 BPs in the funds rate. 

Fed Chair Powell, at his post-meeting news conference, may face questions on why the Fed will continue to tighten aggressively in the face of slowing growth.  He will likely focus on the tight labor market, seen in strong job growth, low unemployment low and a high level of job openings.

The seeming contradiction of slow growth and tight labor market can be explained.  Job growth is catching up to the high level of economic activity, while the rate of change in economic activity is slowing.  Fed staff recognizes the distinction, saying in the July FOMC Minutes that "the projected level of Real GDP remains above potential this year."  From the Fed's perspective, the important aspect of the current situation is the high level of activity, as seen in the very low Unemployment Rate.  The absence of slack puts upward pressure on wage inflation, which, in turn, feeds into higher price inflation.  To achieve more slack requires below-trend economic growth for awhile or, to achieve it quickly, a recession.

The FOMC Central Tendency Projections could show a recession this year.  The average rate of change in Real GDP over the first three quarters of 2022 is -0.6%, using the Atlanta Fed model's latest forecast of +0.4% Q322 Real GDP Growth (q/q, saar).  Real GDP Growth would have to exceed 1.8% in Q422 for the full year change to be positive (by less if Q322 GDP Growth is seen higher than the current Atlanta Fed model's forecast).

Powell will likely reiterate that policy is now data dependent.  So, there is still a possibility of a downshift ahead.  But, another 75 BP hike at the November 1-2 FOMC Meeting may be a good bet.  Note that two 75 BP hikes would put the funds rate at 3.75-4.0%, finally reaching a level that would probably be viewed as restrictive by Fed officials. Perhaps a downshift to 50 BPs would be more agreeable to officials then.

There are two important data points before the November FOMC Meeting -- the September Employment Report (October 7) and the September CPI (October 13).  /1/ Unemployment Insurance Claims data, as well as a number of manufacturing surveys, so far don't suggest a slowdown in September Payroll growth or an increase in the Unemployment Rate.  Nevertheless, Payrolls could slow sharply if they catch up to the sub-300k ADP estimates for July and August.  /2/ Even if the Core CPI slows from the high 0.6% m/m increase in August, it would not be enough to sway the Fed.  As Fed Vice Chair Brainard said, it would take several consecutive months of low CPI prints to persuade her that the trend in inflation is coming down.

Besides upcoming data, there could be a political aspect regarding Fed policy.  Typically, the Fed does not change policy just ahead of an election.  A downshift could be viewed as a change in policy.  So, sticking with a 75 BP hike at the November FOMC Meeting could be defended as being politically neutral, since this tightening pace had been in effect since July.

 

The Last Large Fed Rate HIke?

The stock market looks like it could be looking past the likelihood of a 75 BP hike at the September 20-21 FOMC Meeting, expecting it to be followed by a downshift at the next meeting.  A downshift to 50 BPs after the September meeting is conceivable, as evidence of a slowing economy and continuing pass-through of lower energy prices builds.  But, it's not a foregone conclusion.  This week's US economic data, nevertheless, should encourage this expectation.  

A 75 BP hike at the September FOMC Meeting is still the best bet.  Fed Vice Chair Brainard laid out the reasoning in a speech last week.  She acknowledged the recent decline in commodity prices and the low July CPI.  But, she needs these favorable developments to be sustained to convince her that inflation is being brought under control.  She said, "While the moderation in monthly inflation is welcome, it will be necessary to see several months of low monthly inflation readings to be confident that inflation is moving back down to 2 percent....How long it takes to move inflation down to 2 percent will depend on a combination of continued easing in supply constraints, slower demand growth, and lower markups, against the backdrop of anchored expectations."  These will take time to achieve.  And, she warned that "if history is any guide, it is important to avoid the risk of pulling back too soon."  So, even if the Fed  downshifts after the upcoming meeting, further rate hikes would seem to be likely.

This week's US economic data are expected to be in line with Brainard's prescription for bringing down inflation.  Consensus looks for -0.1% m/m Total and +0.3% Core for the August CPI.  And, the risks are to the downside for both.  Consensus also expects 0.0% m/m for both Total and Ex Auto August Retail Sales.  The drop in gasoline prices is behind both low estimates.  Once again it will be more important to see the Ex Auto/Ex Gasoline Sales print to get a sense of consumer spending.  It has been trending +0.7% m/m over the past few months.  Two manufacturing surveys are expected to be soft this week.   The September Phil Fed Mfg Index is seen falling to 3.5 from 6.2, while the NY Empire State Mfg Index is seen remaining weak at -15.25 after -31.3 in July. 

Brainard commented on the dichotomy between the strong job growth and weak GDP growth.  (The Atlanta Fed model lowered its estimate of Q322 Real GDP Growth to 1.3%.)  She said,"Labor demand continues to exhibit considerable strength, which is hard to reconcile with the more downbeat tone of activity.  Year-to-date through August, payroll employment has increased by about 3-1/2 million jobs, a surprisingly strong increase given the decelerating spending and declining GDP over the first half of the year."  I continue to believe that the dichotomy can be explained as a difference between the level of and rate of change in demand.  Jobs have been catching up to a high level of demand, while demand is slowing.  The dichotomy may be changing.  The latest Claims data suggest that companies may be finally pulling back on hiring.  A further slowdown in Payroll growth can't be ruled out at this point.

August Employment Report Opens Up Potential For Fed Downshifting But Maybe Not

The stock market is likely to remain under pressure as seasonal selling dominates in this data-light week.   The August Employment Report raised the possibility of a downshift in Fed tightening at the September 20-21 FOMC Meeting.  And, the August CPI, due September 13, risks doing the same.  But, it is not clear whether one or two reports will convince the "data-dependent" Fed to pull back from the pace of rate hikes.  There are reasons why the Fed may continue with another 75 BP hike.  Conceivably, the Fed may risk "overshooting" to ensure a sustainably low-inflation economy, which is what an "optimal control" solution would suggest.  This risk could hit the headlines on Thursday, when Fed Chair Powell will likely repeat the Fed's hawkish message in a speech.

The August Employment Report shows some softening in labor market conditions that should be welcome news for the Fed.  Payrolls slowed and the Unemployment Rate rose.  The 0.2 percentage point increase in the Unemployment Rate to 3.7% resulted from an increase in the Labor Force Participation Rate, which means there is more room for the economy to grow.  And, wage inflation moderated, although it is too soon to say the moderation will continue.  The 0.3% m/m increase in Average Hourly Earnings, after +0.5% in July, could just reflect volatility.  

Nevertheless, the slowdown in AHE hints at the possibility that the Unemployment Rate may not have to move much higher to permit inflation to settle down to the Fed's 2% target.  A 0.3% m/m pace (3.6% annualized), is consistent with this target, taking account of the 1.0-2.0% trend in Productivity Growth.  As I discussed last week, there are fundamental reasons why wage inflation may moderate -- the end of the decline in Unemployment and the easing of inflation expectations.

What might keep the Fed aggressive is that the Employment Report shows a strong underlying economy.  The +315k m/m increase in Payrolls is solid, even though less than the huge +526lk July gain.  Although Total Hours Worked slipped in August, the July-August average is 2.7% (annualized) above the Q222 average.  This is close to the 3.0% pace in the prior quarter.  The Atlanta Fed's model raised its projection of Q322 Real GDP Growth to 2.7% before the release of the Employment Report.  

An "optimal control" approach to the issue of how much to tighten suggests maintaining the 75 BP pace of hikes in the face of these mixed data.  Optimal control is a way to maximize an "objective function" subject to constraints.  In this case, the objective function shows the goal of as low as possible unemployment and inflation over the next two years (the time-frame of the Fed's Central Tendency forecasts).  The constraints are the Fed's econometric model, which posits an inverse relationship between unemployment and inflation.  The typical "optimal control" solution of the Fed's model calls for a sharp recession initially.  This allows for faster growth and lower inflation afterwards (my dissertation).  In other words, the economy needs slack to be able to achieve strong growth without stoking inflation.  Currently, the Fed's warning of near-term pain to achieve longer-term growth and low inflation seems to fit this optimal control solution.  If so, the latter suggests that we need to see much more of an increase in the Unemployment Rate to satisfy the Fed -- and thus a continuation of 75 BP hikes.

The next important piece of data is the August CPI, due September 13.   The Total should be depressed by the drop in gasoline prices, while the Core could be held down by the pass-through of lower oil prices to a wide range of other prices as well as by slower wage inflation.

Stocks in Trouble After Powell's Speech, But...

The stock market is in trouble after Powell's hawkish speech at Jackson Hole, particularly in this seasonally weak period.  His comments suggest that Fed tightening won't stop until the Unemployment Rate climbs and Wage Inflation falls.  The market faces the prospect of either a recession or much higher rates.  But, there is a caveat.  Stocks could stabilize if wage inflation slows without a sharp weakening in the economy.

Powell emphasized three developments that are needed to bring down inflation: /1/ A softening in labor market conditions, /2/ below-trend GDP growth, and /3/ low and stable longer-run inflation expectations.  Recent evidence is favorable in terms of the second two developments.  But, not the first.  So, at this point, a 75 BP rate hike at the September 20-21 FOMC Meeting is in play.

Regarding recent evidence:

1. The Atlanta Fed model's 1.6% early estimate is below the 1.8-2.0% long-run trend estimated by the Fed -- a positive from the Fed's perspective, but arguable not low enough.

2. The 2.9% 5-Year Inflation Expectations in the Final-August University of Michigan Consumer Sentiment Survey keeps this measure within its recent range --  a positive from the Fed's perspective.

3.  But, the Claims data have begun to suggest that the recent softening in labor market conditions may be ending.  If Claims continue to be steady or lower, they will reinforce the Fed's view that the labor market is solid and too tight. 

Consensus estimates of this week's key US economic data are not expected to be particularly soft.  If so, they should keep open the door for a 75 BP hike.  Consensus looks for a 0.7 pt dip in the August Mfg ISM to 52.0, pointing to decent growth in the manufacturing sector.  It has to fall below 48.7 to signal contraction.  The fundamentals behind this sector are mixed.  The strong dollar and weaker growth abroad should weigh on exports.  But, the motor vehicle sector seems to be getting out of the chip shortage situation, as assemblies rose in July.  

Consensus expects a moderately strong August Employment Report.  Nonfarm Payrolls are seen slowing to +285k m/m from the huge +528k in July.   But, Payrolls need to rise by less than 100k m/m to be consistent with an increase in the Unemployment Rate.  So, it is not surprising that consensus looks for a steady 3.5% Unemployment Rate.  Moreover, consensus sees Average Hourly Earnings (AHE) rising 0.4% m/m, down from 0.5% in July and in line with the trend in H122.  But, AHE needs to slow to 0.3% or lower to be consistent with the Fed's 2% price inflation target.  

A low AHE print would be a positive market surprise.  And, there is a possibility that wage inflation will slow without a sharp rise in the Unemployment Rate.  There are several reasons.  /1/ The relationship between the level of the Unemployment Rate and Wage Inflation has become tenuous over the past 20-30 years.  Globalization of the labor force may have been the cause, as US workers knew they would risk losing their jobs to imports if wages were hiked too much.  If this factor is still important, the recently strong dollar and surge in immigrants could hold down wage inflation independently of the Unemployment Rate.  /2/  The recent flattening in the Unemployment Rate and decline in commodity prices could slow wage inflation.  The standard Wage Equation has the Change in the Unemployment Rate (as well as its level) and lagged inflation as significant determinants of wage inflation.