Implications of Fed Hawishness

Last week's  hawkish shift in Fed officials' comments and the March FOMC Minutes pulled forward the financial market impact that had been expected from the May 3-4 FOMC Meeting.  The stock and Treasury markets now should trend in ways that support the Fed's goal of bringing down inflation.  This means that stocks will fall and Treasury yields rise further if it doesn't look like the economy is moving in a direction that will lead to a decline in inflation. 

Interpreting real-side economic data could be tricky, however, because of the supply-constraints holding down production.  A weak print may reflect these constraints rather than a softening in demand.  For example, shortage-induced auto plant shutdowns could result in an increase in Initial Claims for Unemployment Insurance Benefits, so the latter should not be viewed as an easing in the underlying demand for labor.  Similarly, a lack of sufficient inventory, not a weaker consumer, could depress retail sales.  To be sure, some of the fundamentals behind the consumer have weakened -- lower saving rate, higher energy/food prices.  Despite this, consensus looks for a speedup in Retail Sales to +0.6% m/m in March from +0.3% in February.  At least some of the speedup reflects higher-priced gasoline sales  The more important part of Retail Sales will be Ex Auto/Ex Gasoline.

If shortages and supply disruptions are holding down economic growth significantly, it doesn't get the Fed off the hook.  It will likely have to aim for an even slower pace of growth than otherwise to bring demand down to the restrained production level, possibly to well below its 1.8-2.0% estimate of longer-run GDP trend.  The result would feel like recession, even if technically not.

Given the difficulty of correctly discerning the import of real-side data, the best evidence to track the Fed's success or failure should be inflation-related measures, themselves.  Besides the CPI and PPI, labor costs and commodity prices will be telling, since they feed into the determination of final goods/services prices. 

The consensus estimate of this week's March CPI does not allay fears of high inflation, with Total expected to jump 1.1% m/m and Core rise 0.5%.  But, there are caveats.  A surge in energy prices, particularly gasoline, is largely behind the jump in Total.  Moreover, there is upside risk to the consensus estimate of the Total as a result.  But, retail gasoline prices already have fallen, and should result in a much more subdued increase in Total in the May Report.  Because of the volatility in energy prices, the Core CPI will be the more important part.  And, while the consensus estimate looks reasonable, a smaller increase can't be ruled out.  Stocks could bounce on a below-consensus print for Core, even if Total comes in higher than consensus.  But, a 0.4-0.5% m/m increase in the Core CPI still would be too high from the Fed's perspective.  So, its hawkish stance should remain.