Optimism Ahead of Key US Economic Data?

The stock market may trade optimistically this week as key US economic data could persuade the Fed to skip hiking rates at the September 19-20 FOMC Meeting.  The August Employment Report should be softer than July's, and it may be soft enough to assuage the Fed.  Even modest softening in Payroll growth and an uptick in the Unemployment Rate -- which is the risk -- may be enough, given Powell's comment that the Fed could "proceed carefully."  The Mfg ISM may tick up, but remain at a low level -- not a surprise for the Fed. 

Powell's speech at Jackson Hole on Friday highlighted the importance of slower economic growth and an easing in the labor market conditions in determining Fed monetary policy.  Two potential triggers of a rate hike are evidence that Real GDP Growth will continue to exceed its long-run trend (1.7-2.0%) and that the labor market is not softening enough.  

The Atlanta Fed model's latest estimate of 5.9% (q/q, saar) for Q323 Real GDP Growth is troublesome from this perspective.  However, it is still an early estimate and could come down as more data become available.  Indeed, softer data over August and September could point to slower GDP growth in Q423, which could comfort the Fed.

Consensus estimates for the August Employment Report may cement expectations for a pause at the September FOMC Meeting.  Consensus looks for Nonfarm Payrolls to slow to +170k m/m from +187k in July.  The Unemployment Claims data support the idea of a slowdown in Payrolls.   However, the consensus estimate still is high enough to keep the labor market under pressure.  The Fed would probably like to see Payrolls rise by about 100k or less to indicate sufficient easing in demand for labor, but it may be willing to wait to see if this degree of jobs slowdown evolves -- as long as the trend is down.  Reflecting a continuation of tight market conditions, consensus sees a steady 3.5% Unemployment Rate.  The Claims data don't rule out a slight uptick in the Rate, however.  Consensus also expects Average Hourly Earnings (AHE) to slow to 0.3% m/m from 0.4% in July.  AHE printed 0.4% in each month since April.  

A 0.3% m/m print in AHE would be a welcome slowdown from the Fed's perspective.  Arguably, it would be consistent with the Fed's 2% Inflation Target once productivity is taken into account.  Moreover, Powell mentioned that wage sensitivity to unemployment may have changed.  This suggests that a moderation in wage inflation in the face of low unemployment could diminish the importance of the latter regarding the inflation outlook.

The other key data this week is the August Mfg ISM.  Consensus looks for an uptick to 47.0 from 46.4 in July.  Evidence regarding the m/m direction is mixed.  The consensus estimate is still below the 48.7 historical demarcation between expansion and recession.  A low, consensus-like print would not surprise the Fed.  Powell mentioned that the trend in Manufacturing Output has been flat this year.

Controlling Fear of the Fed

The stock and Treasury markets may need to see signs of a US economic slowdown to better control their fear of the Fed.  In particular, they may need to see evidence that the labor market is easing.  There are reasons to think this evidence will show up in coming weeks, including softer August Employment and Retail Sales Reports.  So, despite the somewhat hawkish July FOMC Minutes, the question of whether the Fed will hike 25 BPs at the September 19-20 Meeting remains open.

Although FOMC participants acknowledged an improving inflation picture in the July FOMC Minutes, they emphasized potential upside risks stemming from developments such as renewed supply chain problems, an upturn in commodity prices, and an insufficient slowdown in aggregate demand.  The strong start to Q323, as captured by the huge 5.8% (q/q, saar) early Real GDP Growth estimate of the Atlanta Fed model, may have focused the markets on this last risk.  

The strong start to Q323. however, does not mean strength will continue through the quarter.  For example, a large increase in Retail Sales, as in July, typically is followed by 2-3 months of softer sales.  Moreover, while the evidence from the Claims data is not yet complete, at this point it suggests a slowdown in August Payrolls (due September 1) and possibly an uptick in the Unemployment Rate.  Layoffs are up and hiring may have slowed.  Fed officials probably want to see more labor market slack to be less concerned about the inflationary consequences of strong aggregate demand.  

Besides softer real-side economic data, lower commodity prices also may be needed to assuage Fed officials and the markets.  As of now, these prices appear to be off their highs for the most part, but are still well above recent lows.  A decline in oil prices could be particularly important after they jumped in August.  It looks like the associated jump in gasoline prices will add significantly to the August Total CPI.  A sharp downturn in oil prices ahead of the CPI's September 13 release would allow the Fed and markets to dismiss the August jump as temporary.

Ironically, if the latest market turmoil helps slow the economy sharply, the markets may refocus on the other set of risks mentioned in the July FOMC Minutes -- a sharper-than-desired economic slowdown.  This turn of events, however, remains to be seen.

Stock Market Weakness More Than Seasonal?

The stock market has had a hard time rallying on favorable economic data during this seasonally weak period.  Profit-taking after the steep rally in July is reasonable.  The question, however, is whether  something more fundamental is pulling down stocks.  The run-up in longer-term Treasury yields is a potential culprit.   And, it could be tied to the rising Federal deficit and hints that Fed tightening will end soon.  Higher yields serve to crowd out private spending to make room for the fiscal stimulus.  And, the burden to do so falls more on longer-term yields if it looks like short-term rates will not rise much further.  One way private spending is held down is through wealth destruction in the stock market, as the higher long-term yields cut the present value of future earnings.

Many years ago, another economist and I published a New York Fed Research Paper showing that the Treasury yield curve would steepen if the expected Federal Deficit widened.  We augmented the Fed model's term structure equation with the projected Deficit and showed the latter to be statistically significant.  With this in mind, the increased subsidies stemming from the so-called Inflation Reduction Act, which apparently are larger than had been expected, could be a factor behind the run-up in longer-term yields.  On top of this, the sharp increase in Treasury issuance following the debt ceiling fight in June could be exerting a significant temporary boost in yields, as well.  

Some of the run-up in longer-term yields could unwind ahead if congestion from heavy Treasury issuance abates in the next few months.  However, the need to crowd out private spending to make room for subsidized spending suggests longer-term yields will not fall by much, unless the Fed tightens more aggressively.  In the latter case, the short-end of the curve will take on more of the burden to restrain demand.

The more volatile Foreign Exchange market could be a factor lifting longer-term yields, as well.  Our Research Paper showed that the volatility of the dollar in the FX market also impacts the term structure of Treasury yields.  

The actual inflation data are not the issue regarding high long-term yields.  The underlying CPI (Core less Shelter and Used Car Prices) was flat in July for the second month in a row.  And, while the PPI was slightly above consensus, the culprits appear to be narrowly situated in the financial sector.  The longer-run 5-Year Inflation Expectations in the University of Michigan Consumer Sentiment Index slipped back to 2.9% in mid-August.  The Treasury market could be extra sensitive to the recent run-up in commodity prices, however.

At this point, an ending of the downward pressure on the stock market may require an abatement in Treasury issuance and a flattening out in commodity prices.  A sharp decline in commodity prices would not likely help stocks, as it would suggest economic weakness.  This week's US economic data are expected to show this is not the case.  Consensus looks for increases in July Retail Sales, Housing Starts and Industrial Production.  The Atlanta Fed model's latest estimate of Q323 Real GDP Growth is a strong 4.1% (q/q, saar).

 

 

Is A Growth/InflationTrade-Off Right?

The stock market should get relief from this week's July CPI Report, which could print below the already low consensus estimate.  But, it may not be enough to preclude another 25 BP Fed rate hike at the September 19-20 FOMC Meeting.  Friday's July Employment Report kept open this risk, although it argued against a more aggressive policy tightening.   Nonetheless, there is a way to interpret the jobs data in a favorable way regarding the inflation outlook that could hold back the Fed at some point.

Consensus looks for +0.2% m/m in both Total and Core CPI.   This would be close to the Fed's annualized 2.0% target for the second month in a row.  Moreover, a 0.1% print for both can't be ruled out.  Owner's Equivalent Rent needs to rise no more than 0.5% (as in June), used car prices and airfares fall, and hotel rates flatten out.  For a below-consensus Total, food at home prices need to fall, as well, which is suggested by recent softness in PPI food prices.  

Whether a low CPI is enough to persuade the Fed to hike once and pause or to pause in September could depend on its view of the labor market.  Friday's Report showed the latter to be still tight, with the Unemployment Rate slipping to 3.5% and wage inflation remaining high at 0.4% m/m.  It keeps open the door for a September hike.  However, the latter is still not a foregone conclusion, since the Fed will see the August Employment Report before the September meeting.  And, the BLS will release its estimate of the Benchmark Revision to Payrolls on August 23 -- possibly revising down the trend in job growth.

In any case, there may be a way to interpret the latest data to draw a more positive view of the inflation outlook.  More than half of the Payroll gain was in Health, Education and Government.  While their demand for workers helps to keep wage inflation high, other sectors look like they are trying to economize on high-cost labor by cutting jobs and the workweek.  These efforts should help offset higher wage rates and hold down prices.  And, they may not reduce output if offset by higher productivity of the retained workers.  

Last week's Q223 Productivity Report was encouraging in this regard.  The 4-quarter trend in Productivity is now 1.3%, up from -0.2% over 2021-202 and close to the pre-pandemic pace (1.6% over 2017-19).  With the latest Atlanta Fed model's estimate of Q323 Real GDP Growth at 3.9% (q/q, saar) and July Total Hours Worked only 0.3% (annualized) above the Q223 average, another strong increase in productivity seems possible in Q323. 

Strong Productivity offsets the impact of fast wage growth on price inflation.  Unit Labor Costs  (Compensation Growth Less Productivity Growth) averaged only 0.9% (q/q, saar) over the past 3 quarters.  It may be one reason why core inflation could be slowing.  The large wage increases could be viewed as labor capturing part of the productivity gain and not requiring a pass-through to prices.  In this view, the Fed could tolerate the high pace of wage increases and pause in its tightening.