Stocks To Face Unfriendly FOMC Meeting This Week

The stock market remains in trouble as the higher-than-expected May CPI (and jump in the University of Michigan 5-Year Inflation Expectations) should reinforce the Fed's hawkish policy stance at this week's FOMC Meeting.  This doesn't mean the Fed will decide to hike by 75 BPs rather than the pre-announced 50 BPs, although Fed Chair Powell has been known to change his policy view after the release of some problematic data.  But, the Fed's Central Tendency Projections could lift the  trajectory of the funds rate sharply.  Also, the tone of the Statement and Powell's post-meeting news conference may not hint at any relaxation in the pace of tightening ahead. 

While the 1.0% m/m May Total CPI was high, there may be less behind it than meets the eye from the Fed's perspective.   44% of the Core components had m/m changes of 0.3% or less, compared to 36% of their prior 3-month averages.  Moreover, the jump reflected to a large extent supply issues: the embargo on Russian oil, the cutoff of Ukrainian food exports, and shortages of materials and components used in motor vehicles -- either directly in food and energy prices or in pass-throughs, like airfares.  (The CPI jump also reflected a catch-up to the run-up in rents since the end of the pandemic.)  All are factors over which the Fed has no control other than by restraining aggregate demand.  And, this could have little effect if the rest of the world, particularly China, grows quickly.  Or, if OPEC cuts production as demand for oil falls.  In a sense, the Fed may be only repressing US demand to allow the rest of the world to consume more of these commodities -- netting to little change in their prices.

This world-wide, commodity-driven problem shows that what is going on is not so much an inflation story as a relative price shift event.  The surges in energy, food and other commodity prices reflect supply-demand imbalances that are being eliminated through relative price changes.  Higher prices reduce demand for these items and encourage increased supply. The widespread impact of higher oil prices, however, makes the situation look like general inflation.

From this perspective, the Fed's goal should be to prevent wage rates from climbing in response to the higher prices, that is to prevent a wage-price spiral.  This goal could be difficult to achieve, since the relationship between wage inflation and unemployment has been loose, as Fed Chair Powell, himself, has acknowledged in testimony.  So, increasing the Unemployment Rate may have only a small effect on wage inflation.  To be sure, the slowdown in Average Hourly Earnings to a modest 0.3% m/m trend since February is encouraging.  It raises the possibility that the Fed will not have to tighten much to keep wage inflation from speeding up.  But, AHE is the narrowest of the major measures of labor costs and may not be telling the whole story.  Nevertheless, Labor Costs rather than Price Inflation perhaps should become the important data by which to evaluate Fed policy. 

How far the Fed thinks it will have to slow the economy will be apparent in the Central Tendency Projections released at this week's FOMC Meeting.  The market will probably be looking to see if these projections embody a recession or close to a recession.  The March Growth Projections will certainly have to be lowered, as they looked for an above-trend pace in 2022 and 2023 (see below).

The March projections also show expectations for the year-end Fed Funds Rate of 1.6-2.4% in 2022 and 2.4-3.1% in 2022.   These projections will be raised.  A 3.5% Funds Rate for 2022 would imply a 50 BP hike in each of the five FOMC Meetings from June through December.  A 2.75% Rate for 2022 would imply 50 BP hikes in June and July and then a downshift to 25 BPs in the 3 Meetings from September through December.   Note that Fed officials have said a neutral rate is 2.5%.

These projections were made before the May CPI was released, so Powell could emphasize upward risks to them at his news conference.  The cumulative increase in the projected funds rate has become more important to the markets than the actual hike at the Meeting.  That is one reason why the market reactions have been larger than historical comparisons would suggest.

                                    Central Tendency Projections at March FOMC Meeting*

                                                2022            2023

Real GDP Growth                2.5-3.0            2.1-2.5        

Unemployment Rate            3.4-3.6            3.3-3.6            

PCE Inflation                        4.1-4.7           2.3-3.0            

Core PCE Inflation               3.9-4.4           2.4-3.0 

*  Q4/Q4 Percent Change, Except for Q4 Average for Unemployment Rate.