The Bad And The Good In The July FOMC Minutes

The July FOMC Minutes had good as well as bad news for the markets.  Bad News -- The Fed is intent on reducing inflation by tightening further.  Good News -- Although officials acknowledge the possibility of overshooting, their data-dependent approach to policy decisions would enable them to respond quickly by adjusting the pace and magnitude of tightening.   It suggests there could be a "Fed put" at some point.  

These ideas could be repeated by Fed Chair Powell and other Fed officials at this week's Jackson Hole meeting.  So, the "bad" implications of the Minutes may continue to weigh on stocks, particularly in this seasonally weak period.  But, the market could shake off its fear of tightening if upcoming US economic data, such as this week's July PCE Deflator, argue for a downshift in rate hikes to 50 BPs from 75 BPs. 

The July FOMC Minutes had three main messages for the markets -- /1/ rates will continue to be hiked until sustainable 2% inflation is achieved,  /2/ the pace of tightening would likely slow at some point once the cumulative effect of past rate hikes starts to bite the economy, and /3/ rates would likely be held steady at that point in order to ensure that 2% inflation is sustainable.  

The Fed's hope is to achieve its inflation target without a recession.  The Minutes, however, contain a fairly detailed analysis of the inflation problem that raises doubts on whether a sustainable 2% inflation rate can be obtained without a hard landing, that is recession.  Fed staff, as well as officials, acknowledge that the economy is operating at a level above its long-run potential.  Growth has to fall below its long-run 1.8-2.0% trend to bring the economy to a level that does not precipitate inflation.  Although the Minutes don't say this explicitly, the Unemployment Rate has to rise significantly -- which could entail a recession.  

To be sure, there could be mitigating factors helping to push down inflation without the need to boost unemployment.  The Minutes list /1/ competitive pressures that restrain price increases, /2/ "the apparent absence  of a wage-price spiral, " /3/ the tightening of monetary policy outside of the US, /4/ an easing of supply constraints, and /5/ the dollar's appreciation holding down import prices.  While lower commodity prices should continue to help lower inflation in the next few months, Fed officials view commodity prices as a "potential source of upward pressure on inflation."  Moreover, even with the mitigating factors, they think that "a slowing in aggregate demand would play an important role in reducing inflation pressures."

Although monetary policy aimed at slowing the economy is not good for the stock market, the Minutes indicated that officials would try to avoid going too far in trying to restrain the economy.  Many participants agreed that the tightening could be "more than necessary to restore price stability."  They believe, however, that the Fed's "data-dependent approach" to tightening will be an important element helping them mitigate that risk.  Presumably, this means the Fed will stop tightening or possibly ease if the economy's weakening appears to be excessive.  This possibility should cushion the impact of upcoming  monetary policy tightening on the stock market.

This week's US economic data are likely to leave open the possibility of a downshift in Fed tightening.   Consensus looks for a 0.3% m/m July PCE Deflator, the same pace as the Core CPI.  And, there is downside risk to the consensus estimate, based on the different compositional weights in the two inflation measures.  Housing data are expected to weaken further, with July Pending Home Sales and New Home Sales falling.  Manufacturing data, however, are expected to increase, with July Durable Goods Orders up modestly.