US Economic Data Not Soft Enought For Fed So Far

The stock market has to contend with speeches by Fed Chair Powell and other Fed officials this week, in which they will likely continue to threaten further rate hikes ahead.  Their emphasis on more hikes makes for a high hurdle to prevent one at the next FOMC Meeting.  Indeed, last week's US economic data-- Unemployment Claims and Housing data -- were not soft enough to argue for another pause.  This week's calendar contains the important May PCE Deflator, which risks printing softer than consensus.  However, a soft print is probably not enough to stop the Fed from hiking in July.  An extremely weak June Employment Report may be required, as well.

Consensus expects +0.4% m/m for the May Core PCE Deflator -- the same as the increase seen in the Core CPI.  This estimate risks being too high for reasons mentioned in last week's blog.  In particular, a jump in Used Car Prices accounted for more than 0.1% pt of the Core CPI's increase.  Used Car Prices, however, do not enter the PCE Deflator significantly.  A low Core PCE Deflator print, by itself, would probably not be enough to dissuade the Fed from tightening, as a one-month print is not a trend.  Moreover, a 0.3% print still would be above the Fed's target.

The Fed will probably need to see signs that a recession has begun.  Data released so far don't say this.  The Unemployment Claims data say the labor market has weakened, but the weakness is not snowballing.  Initial Claims stayed high in the latest week, but unchanged from the prior week.  Despite the high level of layoffs, Continuing Claims fell.  The latter suggests hiring remains strong.  To be sure, the Claims data still point to a slowdown in June Payrolls (one more week's data is needed for a complete picture).  However, they do not hint at a sub-100k print, which is what may be needed to get the Fed to consider pausing. 

Last week's Housing Starts/Permits data clashed with Fed Chair Powell's depiction of the housing sector as being hurt by past rate hikes.  His depiction may be rear-view.  The increases in May Starts and Permits -- both for 1-Families and Multis -- raised the possibility that the impact of past rate hikes on this sector is no longer dominant.  Underlying factors, such as population growth and household formation, may be reasserting themselves in housing demand.  While the Starts/Permits jumps may be one-off in terms of magnitude, 1-Family Starts have now risen in each month since February.

The manufacturing sector also may not be as weak as some surveys suggest.  The decline in the Markit US Mfg PMI to 46.3 in June may be just catch-up to the levels seen in the Mfg ISM in prior months.  Evidence for the June Mfg ISM so far is mixed.  Hard evidence regarding manufacturing will be seen in this week's report on May Durable Goods Orders.  Consensus looks for -1.0% m/m for Total, but this is just an unwinding of the +1.1% jump in April.  Ex Transportation Orders are seen slipping 0.2%, which would just extend a modest descent similar to the -0.1% in April.  The Fed's Industrial Production Report shows Manufacturing Output up 2.4% (saar) in April-May over Q123 -- clearly not a sign of recession in this sector.

Overall, the Atlanta Fed model's estimate of Q223 Real GDP Growth is now 1.9% -- in line with the long-term trend estimated by the Fed.

 

Fed Policy Remains "Live"

The stock market's rally should not be derailed by Fed Chair Powell's threat of a rate hike at the July 25-26 FOMC Meeting.  First, it may not happen, as US economic data could soften sufficiently to satisfy the Fed that its forecast is on track without additional rate hikes.  Second, a 25 BP hike should not seriously damage the economy.

The most important point made by Fed Chair Powell at his news conference is that the July FOMC Meeting will be "live."  In other words, a rate hike at that meeting will be discussed and is a strong possibility.  Presumably, a rate hike will be decided on if evidence points to paths for the economy, labor market and inflation that are stronger than the Fed's Central Tendency forecasts.  Indeed, evidence of significantly slower growth, easier labor market and lower inflation may be required to persuade officials to pause next month.   Significant weakness in the data may persuade Fed officials that two more hikes will not be needed to achieve their forecasts -- in contrast to what they currently believe.  To be sure, this belief does not mean a hike in July is guaranteed, since the Fed will have more opportunities to do so in the rest of the year.  

The new information from major US economic reports ahead of the July FOMC Meeting will be the May PCE Deflator, June Employment Report and June CPI.  At this point, the risk is for all three to soften sequentially.  It is not clear, however, whether they will soften enough to keep the Fed on hold.  Moreover, evidence of slower growth and inflation from these key data may require support from other data, as well, such as rising Unemployment Benefit Claims and falling commodity prices.  A stronger dollar in the FX market could play a role in the Fed's decision, as well.  Note that the threat of further rate hikes, itself, should help boost the dollar and hold down commodity prices.

A slowdown in the Core PCE Deflator to 0.2-0.3% m/m in May from 0.4% in April is a reasonable expectation, based on the 0.4% May Core CPI.  More than 0.1% pt of the CPI's increase resulted from the jump in Used Car Prices.  These prices are essentially absent in the calculation of the PCE Deflator.  What appears to be the main reason for inflation remaining high is housing rent.  The Core CPI less Shelter and Used Cars has slowed each month since January and was only 0.1% in May.  The irony is that tighter monetary policy may work against a slowdown in rent by pushing people to rent rather buy a home.  Nevertheless, the CPI's measure of housing rent presumably will reflect the earlier sharp slowdown seen in private surveys at some point. 

Powell rightfully says that core inflation -- Total Less Food and Energy -- is better than overall inflation prints in indicating the underlying trend.   Nevertheless, Food and Energy Prices should not be dismissed entirely for being volatile.  Standard models say these prices influence wage inflation through inflation expectations and contract negotiations.  For example, high food inflation push labor to demand higher wages to offset the drag on spending power.  So, the stabilization of energy prices and the recent decline in food prices, seen particularly in the forward-looking PPI, are another reason, besides higher Unemployment, that could dampen wage inflation ahead. 

The Claims data indicate a softer labor market so far in June.  Initial Claims are 24k above the May average, as layoffs picked up.  Continuing Claims have turned back up.  At this point, the Claims data suggest a slowdown in June Payrolls.

 

A Summer Rally After A Fed Pause?

A Fed decision to pause in rate hikes at this week's FOMC Meeting may be met by some profit-taking in the stock market, but it will help set the stage for a summer rally.  A pause would signal that the Fed wants to keep the cost of reining in inflation low, allowing the latter to be achieved through slow growth rather than recession.   Moderating inflation along with modest economic growth should be a positive for stocks.  This week's US economic data may very well point to such a combination.  

This week's inflation data risk being on the soft side.  To be sure, consensus looks for a still-high May CPI, with +0.2% m/m Total and +0.4% Core.  But, there is downside risk to both, as I mentioned last week.  Moreover, there is room for a further slowdown in Core in coming months through a slowdown in the CPI's measure of housing rent.  The moderation in labor costs (see last week's blog) and commodity prices, as well as the somewhat stronger dollar (the effect of which could show up in this week's May Import Prices release), bode well for an inflation slowdown ahead, as well.  Consensus also looks for a benign May PPI, with -0.1% m/m Total and +0.2% Core.

This week's real-side data are expected to show slow, but positive growth.  Consensus expects May Retail Sales to dip 0.1% m/m in Total but increase 0.1% Ex Auto, after +0.4% for both in April.  There is some upside risk, reflecting the tendency for sales to recover from a very weak period for several months (sales fell in February and March).  Also, news reports of good mall traffic over the Memorial Day weekend may show up in the figures.  Another report regarding the consumer will be the Mid-June University of Michigan Consumer Sentiment Index.  Consensus sees an uptick to 60.5 from 59.2 in May.  The more important part of the survey will be the 5-Year Inflation Expectations.  The question is whether they  return to their 2.8-3.0% range after rising to 3.1% in May.  A return would assuage fears that longer-run inflation expectations are becoming unhinged.

Consensus also looks for a 0.1% m/m increase in May Industrial Production.  The risk is for Manufacturing Output to edge up, as well, based on Total Hours Worked.  An increase in the latter would put the April-May average about 2.0% (saar) above the Q123 average, raising doubt about the significance of the weak manufacturing surveys seen in recent months.

Stock Rally Should Continue -- Good News on Wage Inflation

The stock market's pullback lasted one day last week, ending after top Fed officials signaled the likelihood of a pause in rate hikes at the June 13-14 FOMC Meeting.  A pause should bolster economic growth.  At the same time, inflation may remain contained, as surprisingly softer data on the wage front were released last week.  Slower wage inflation supports a Fed decision to pause and could help lift corporate earnings.  In all, the latest macroeconomic developments should help sustain the stock market rally.

There were several "good" pieces of evidence regarding wage inflation last week.  There was a large downward revision to Compensation Per Hour in a report the market typically ignores.  Wage inflation in the May Employment Report eased back to a moderate trend despite a surge in jobs, and the high April wage print was revised down. 

Major downward revisions to Compensation/Hour -- the broadest measure of labor costs -- significantly lowered upside risks to inflation (see table).  Rather than showing an acceleration in the trend of labor cost inflation, as the prior preliminary data had shown, the revised data show a slowdown to a 3.0% or lower pace consistent with the Fed's 2% price inflation target -- taking account of an uptrend in productivity.  

                                            Compensation/Hour (percent change)

                                      (q/q, annualized)                     (From a Year Ago)      

                                    Revised        Prior                    Revised        Prior

        Q123                   2.1                3.4                         3.0                5.0       

        Q422                  -0.7               4.9                          3.0                4.5           

The May Employment Report had a lot of favorable features for the Fed and stock market, besides a slowdown in wage inflation.  Although Payrolls surged (which was the risk), other parts of the Report were benign.   Despite the jump in jobs, Total Hours Worked (THW) dipped as the Average Workweek slipped.  THW so far in Q223 are flat relative to the Q123 average, pointing to modest GDP growth this quarter.   The Atlanta Fed model's latest estimate is 2.0%.  When combined with the 1.3% GDP growth in Q123,  economic growth may be below trend in H123.  Indeed, the 0.3% point jump in the Unemployment Rate to 3.7% could be catch-up to this slow pace.  It is clearly in the right direction for the Fed.  Moreover, the 0.3% m/m increase in Average Hourly Earnings, after a downward-revised 0.4% in April (was 0.5%), equals the prior 3-month average and shows a further containment of labor cost inflation so far this quarter -- perhaps a result of the easing in labor market conditions.  The annualized m/m increase is roughly in line with the 3.0% trend in Compensation/Hour.

There is a possibility of a slowdown in the May CPI, due June 13.  It would require flattish Used Car Prices and Airfares, as well as declines in some areas.  At this point, a 0.1-0.2% m/m Total CPI and 0.3-0.4% Core can't be ruled out.  Both rose 0.4% in April.