This Week's Key US Economic Data and FOMC Meeting: Market Positives?

The stock market is likely to enter the week with positive expectations of a downshift in Fed rate hikes at the FOMC Meeting and softer key US economic data.  But, the FOMC Meeting and key US economic data may not resolve the issue regarding the endpoint of Fed tightening, a continuation of which could temper the market rally.  Although the Fed is likely to downshift to a 25 BP rate hike at the Meeting, it should keep open the door for additional hikes ahead.  This possibility risks being underscored by above-consensus prints for the January Mfg ISM and Payrolls. 

The market will probably view Tuesday's Q422 Employment Cost Index (ECI) as an important input into the Fed deliberations, since Fed Vice Chair Brainard highlighted it in her speech.  But, its importance may be exaggerated for reasons discussed below.  Consensus expects the ECI  to slow to 1.1% from 1.2%.  A slowdown in the ECI, though, is not a slam-dunk, as the evidence is mixed.  Lower sales commissions, resulting from fewer autos and homes sold, may hold down the ECI.   But, Average Hourly Earnings (AHE) did not slow in Q422, when measured over the 3 months of the quarter (which is how the ECI is measured).  Both moved in the same direction in each of the prior 3 quarters (see table below).  And, even if the consensus estimate prints, the y/y would rise. 

AHE and ECI do not measure labor costs the same way.  ECI looks at wage and benefits for specific occupations and is not affected by compositional shifts among them, unlike AHE.  But, as I have argued, a compositional shift toward lower-paid workers, -- either by substituting new, younger workers for retiring older workers or by reducing overtime through hiring additional workers  -- can play a role in reducing price inflation.  So, the ECI may not tell the whole story regarding labor costs and price inflation.  It's unlikely that an above-consensus print for the Q2ECI will prevent the Fed from downshifting.

Although not typically getting much market attention, the Productivity/Unit Labor Cost Report for Q422 is expected to have good news regarding the inflation outlook.  Nonfarm Productivity is seen rising an above-trend 2.4% (q/q, saar) and Unit Labor Costs (ULC) rising 1.5%.  ULC incorporates the broadest measure of labor costs, Compensation/Hour.  The consensus estimates imply 3.9% for it.  This would be a speedup from 3.2% in Q222, but would put the Q4/Q4 increase at 2.9%, versus 5.2% in 2021.

Consensus could be underestimating other data due this week, as well.  Consensus looks for another dip in the January Mfg ISM.  But, a number of other manufacturing surveys suggest an uptick.  Consensus expects a slowdown in January Payrolls to +185k m/m from +223k in December.  But, the Claims and other evidence suggest a speedup.   For one, seasonal factors could overly boost jobs in Retail, Couriers and Temporary Help, to the extent the seasonals overly depressed them in November or December.  In this case, the market could discount a strong Payroll print as being one-off. 

Other parts of the January Employment Report could move in a Fed-friendly way.  Consensus sees the January Unemployment Rate moving back to 3.6% after it unexpectedly dipped to 3.5% in December.  The Claims data suggest upside risk to consensus.  Consensus also sees a modest 0.3% m/m increase in Average Hourly Earnings, an increase that would be consistent with 2% (annualized) price inflation after taking account of trend productivity growth.   Away from the Employment Report, consensus sees a 300k decline in December Job Openings to 10.2 Mn.   This would be in the "right" direction, but still well above the pre-pandemic 7.0 Mn level.  So, it would not close the door on more rate hikes ahead.

                                                         Table

                   Average Hourly Earnings and Employment Cost Index

 (Qtr-End to Qtr-End 3-Month Percent Change)            y/y percent change

                               AHE                       ECI                  AHE         ECI          

Q122                      1.2                          1.4                     5.6           4.5

Q2                          1.1                          1.3                     5.2           5.1     

Q3                          1.0                          1.2                     5.1           5.0    

Q4                          1.0                          1.1 (e)               4.6            5.2 (e)

Fed Downshifting Versus Risk of Recession

The stock market will likely continue to contend with the risk of recession, but the possibility of a further downshifting in Fed rate hikes to 25 BPs from 50 BPs may very well win out. 

Fed Vice Chair Brainard's speech last week spells out how inflation can be beaten without necessarily a recession.   It also reiterated that interest rates would remain at restrictive levels for an extended time, although did not mention how much further or how fast they will climb from here.  But, her analysis, described below, suggests that not much more tightening will be needed.  So, the door remains open for another downshift in Fed rate hikes at the January 31-February 1 FOMC Meeting, particularly since other Fed officials appear to be favoring a 25 BP hike. 

Brainard expects the US economy to slow further this year, as the lagged impact of last year's tighter monetary policy takes hold.  The labor market already is beginning to cool, as she cites the declines in the Nonfarm Workweek, Temporary Help Services and Payroll Growth.  Also, the labor force has been constrained by the extraordinary increase in retirements and the impact of long-COVID symptoms.  And, immigration has been low.  

She also saw reasons for a slowdown in inflation without a recession.  Softening import prices,  easing supply constraints, inventory rebuilding and weaker demand has lowered Core Goods Inflation.  Slowdowns in wage rates and other factors could continue to help slow Non-Housing Services Inflation.  And, Housing Services Prices should begin to reflect the declines in new leases by the summer.  Finally, longer-run inflation expectations appear to be well-anchored.  

Last week's US economic data did not resolve the question of recession or slowdown in 2023.  Weakness in December Retail Sales and Industrial Production keep open the possibility of recession.  But, other data were not as weak.  The January Phil Fed Mfg Survey's components suggest a stabilization in the manufacturing sector, although the overall Index remained negative.  December Housing Starts fell, but the decline was in the volatile Multi-Family Units.  1-Family Starts rose.  And, the Claims data remained low, not rebounding from the low prints in the prior two holiday weeks.  These data suggest a speedup in January Payrolls.

Next week's US economic data also may not resolve the recession/slowdown debate.  Consensus looks for another decline in the Leading Indicators, raising the possibility of a recession in early 2023 according to the Conference Board.  But, December Durable Goods Orders are seen rebounding and Consumer Spending slipping only 0.1% m/m -- less of a decline than seen in Retail Sales.  Consensus expects the first-print of Q422 Real GDP to be up 2.6%.  This is below the Atlanta Fed model's 3.5% estimate.  While both are above trend, an in-line print could be viewed as "history" by the markets.  The December Core PCE Deflator is seen at +0.3% m/m, the same as the Core CPI.

Are US Data Pointing to a Downshift in Fed Rate Hikes?

The stock market should continue to move up ahead of the January 31-February 1 FOMC Meeting, as the latest (as well as expectations of upcoming) data keep open the door for a further downshifting in Fed rate hikes to 25 BPs from 50 BPs. 

The December CPI had a number of favorable elements from the Fed's perspective, even though the 0.3% m/m Core was above the Fed's inflation target.   A decline in motor vehicle prices and car rental prices provided more evidence that easing supply constraints will unwind earlier shortage-induced price hikes.  Most other prices posted subdued increases.  Food prices, both in the grocery store and restaurants,  slowed -- a positive factor for lowering inflation expectations and suggestive of a moderation in labor costs.  And, while Housing Rent remained high, it should catch up to the declines seen in recent surveys as the year progresses.  The Core CPI Less Housing, which Fed Chair Powell likes to cite, fell 0.1% m/m for the 3rd consecutive month.  Note, however, that some of the weakness in this measure reflects the pass-through of lower fuel costs to airline fares and a technical issue with how health insurance costs are measured -- not, as Powell suggests, because of slower wage increases.

Besides the favorable elements of the December CPI, inflation expectations appear to be contained, according to the University of Michigan Consumer Sentiment Survey.  The Fed's favorite measure, 5-Year Inflation Expectations, was  3.0% in mid-January, remaining within its recent range.

The increase in the overall Michigan Sentiment Index should help allay fears of recession, as it suggests the consumer is in decent shape.  Similarly, the Unemployment Claims data suggest some improvement in labor market conditions, although these data have to be viewed with caution because of holidays in the reported weeks.  If seasonal factors did not adequately offset holiday-related declines in Claims (both Initial and Continuing), they could overly boost them in next week's report.  As they stand, the Claims data raise the risk of a speedup in December Payrolls.

In contrast to the Claims data, data due this week are expected to show a soft ending in 2022.  December Retail Sales are seen falling, both Total and Ex Auto.  Price declines likely play a role in these estimates.  An unwinding of some of October's strength could play a role, as well, since a pause after a strong month could last for a couple of months.  December Industrial Production is expected to fall.  A decline in Manufacturing Output would be consistent with Total Hour Worked in the sector.  December Housing data also are expected to weaken in this week's reports.  All these weaker reports would be consistent with the Fed's desire for an economic slowdown, but they could help persuade the Fed to downshift.

More Fed Downshifting?

Continuation of the stock market's rally may depend on /1/ economic data pointing to a further downshifting in Fed rate hikes from 50 BPs to 25 BPs and /2/ better-than-expected Q422 corporate earnings.  With these issues in mind, the market this week will face a speech by Fed Chair Powell (Tuesday), the December CPI (Thursday), and the start of earnings season.   

Powell is not likely to change the odds regarding a further downshifting in rate hikes.  He will probably reiterate the Fed's commitment to lower inflation and the data-dependency of policy.   At this point, not enough data has been released to be confident about the outcome of the next FOMC Meeting.  Some Fed officials have said they are open to either 25 or 50 BP hike, so a further downshifting is not out of the question even if Powell does not mention it in this week's speech.

The consensus estimate for the December CPI (0.0% m/m Total and +0.3% Core) is borderline with respect to Fed policy.  The risk is that the Total CPI will fall, based on the drop in gasoline prices.  But, this can be viewed as one-off.  Although a 0.3% Core lowers the y/y to 5.7% from 6.0%, it is a speedup from November's +0.2% and above the Fed's 2% (annualized) target.    Moreover, the risks are two-sided.  A lower-than-consensus Core can't be ruled out.  But, it may require a larger drop in Airfares than in November, a slowdown in Owner Occupied and Primary Rent, heavy holiday discounting, or a continuation of lower Medical Care Services Prices (reflecting health insurance measurement).  A rebound in the latter could push the Core CPI up to +0.4%.

The December Employment Report kept open the door for the Fed to downshift -- even though Payrolls were strong and the Unemployment Rate fell.  First, wage inflation may be slowing to a reasonable pace.  The +0.3% m/m in Average Hourly Earnings, after a downward-revised +0.4% in November, is in line with the Fed's 2% price inflation target, taking account of productivity growth.  Second, economic activity appears to be slowing.  Total Hours Worked (THW) dipped 0.1% m/m, keeping it in a flattish range since September.  The December level is 0.5% (annualized) below the Q422 average -- a weak take-off point for Q123.  For the quarter as a whole, THW rose 1.1% (q/q, saar) in Q422 versus +2.3% in Q322.  THW was particularly weak in the Nondurable Manufacturing Sector, pointing to another decline in Manufacturing Output in the December Industrial Production Report.

There is a way to reconcile the strong headline prints (Payrolls and Unemployment Rate) and the underlying softness of the data.  Companies may be hiring people to eliminate high-cost overtime among existing workers.  This could entail hiring part-timers, which, in fact, the data show happened in November and December.   In addition, a shift to part-timers or reduced hours for existing workers could reflect companies' cautious approach to a softening in demand for their products.  These shifts could explain the continuing large job gains and fall in unemployment, while reducing overall hours worked.  They also could help explain the slowdown in wage inflation.

This Week's Key US Economic Data

A move-up in the stock market may require "goldilocks" prints in this week's releases of key US economic data.  The December Employment Report needs to show a softening in labor market conditions, but not so much as to suggest recession.  Also, and perhaps more importantly, Average Hourly Earnings need to slow.  In addition, the November JOLTS data need to have Job Openings decline significantly.  To a lesser extent, the December Mfg ISM needs to suggest a slowdown in the manufacturing sector, not a downturn.  This combination of prints should support a continuation of moderate Fed rate hikes, with a possible end in sight.  And, it would suggest that the financial markets don't have to "work" as hard to achieve the Fed's goals of slower economic growth, easier labor market conditions and lower inflation.

Most evidence points to a slowdown in December Payrolls and an increase in the Unemployment Rate.  Consensus, however, only looks for a slowdown in Payrolls -- to +200k m/m from +263k in November.  A sub-200k job gain would likely be more to the Fed's liking.  Consensus sees a steady 3.7% Unemployment Rate.  This estimate may be too low.  The increase in the Insured Unemployment Rate, based on the Claims data, points to 3.8-4.0%.  Consensus expects +0.4% m/m for Average Hourly Earnings (AHE).   This would be back to the earlier trend, after large increases of 0.5-0.6% in the prior two months.  While a slowdown in AHE would be a relief, the pace needs to slow to 0.3% or lower to bring it in line with the Fed's 2% price inflation target (taking account of productivity growth).   There is no evidence regarding AHE. 

Consensus expects Job Openings to fall to 10.0 Mn in November from 10.3 Mn in October.   This would be a notable decline, but would still leave Openings well above the 7.0 Mn pre-pandemic trend.  A large decline such as with the consensus estimate would likely support the idea that Fed tightening is working successfully to eliminate excess demand for labor.  But, it would keep further rate hikes on the table, as the problem of excess demand for labor would still be apparent.

Consensus looks for a decline in the December Mfg ISM to 48.5 from 49.0.  This would put it below the 48.7 level that signals a downturn in the manufacturing sector.  The evidence regarding the December Mfg ISM is mixed.  Some regional surveys show an uptick in manufacturing, while others show a decline.  The increase in the Chicago PM raises upside risk.  But, it is no guarantee.  Although Chicago PM has been the most reliable predictor of the m/m direction in the Mfg ISM since April, it has a mixed record for the month of December -- correct only half the time in the past 6 years. 

The Unemployment Insurance Claims data remain important to assess whether the economy is moving into recession.  So far, however, they are inconclusive.  Initial Claims have not moved up as much as they have prior to past recessions, but Continuing have.  There may be less significance of the increases in both if efficiency drives by companies rather than responses to weaker demand are behind them.