Unfriendly Fed and Labor Cost Data This Week?

The stock market may continue trying to regain the ground lost after Fed Chair Powell pulled back the likelihood of near-term rate cuts, helped by strong corporate earnings.  However, the market risks facing an unfriendly FOMC Meeting (although with the possibility of one saving grace) and troublesome labor cost data this week.

The Fed is not likely to change its new, somewhat hawkish stance at this week's FOMC Meeting, despite the ironically soft 1.6% Q124 Real GDP print.  Even though the low print is in line with the initial Fed projections for 2024 -- making their upward revision look foolish -- the slow growth did not prevent inflation from speeding up last quarter.  Together, the slow growth and high inflation should keep Fed policy steady, probably through the elections.  Powell should reiterate that the Fed wants to see more months of evidence to determine whether inflation is on a downtrend.  To be sure, all this should be old news.  The market may like his comments if, as is likely, he leaves the possibility of rate cuts at some point on the table.

This week's evidence on labor costs risks being unfriendly for the Fed.  All three of the major measures -- Average Hourly Earnings, Employment Cost Index and Compensation/Hour -- will be released and may exceed consensus in some cases.

Consensus looks for the Q124 Employment Cost Index (ECI) to speed up to 1.0% (q/q) from 0.9% in Q423.  Supporting this estimate, a curious inverse relationship with Average Hourly Earnings (AHE) in the past couple of years suggests ECI could match or exceed the Q423 pace -- when AHE slowed, ECI sped up and vice versa (see table below).  It is not clear why this inverse relationship holds, but it represents an upside risk.  ECI includes forms or compensation that AHE does not, such as bonus payments and health insurance premiums paid by employers.  These could boost the ECI in Q1 of a year. 

Consensus also looks for +0.3% m/m in April AHE.  This would be a favorable print.  However, last year, AHE sped up in April after low prints in February and March (as was the case this year too).  So, there is upside risk to the consensus estimate, too.

Consensus expects 4.0% (q/q, saar) for Q124 Compensation/Hour.   The risk is for a print closer to  5.0%, based on Personal Income and THW data.  The market and Fed may take a cautious view of a high print, however, since Compensation/Hour tends to be volatile on a quarterly basis.  Last year,  it varied between 3.6% and 6.5% among the four quarters, averaging 5.2%.

            (q/q percent change)

            AHE            ECI

Q124   0.97                 na

Q423   1.02                0.9

Q323    0.8                1.1    

Q223    1.2                1.0    

Q123    0.8                1.2

Q422    1.2                1.1

Q322    1.1                1.2

The low 1.6% Q124 Real GDP pace is not entirely surprising, despite the 2+% estimates of the Atlanta Fed model and consensus estimates.  The fact that the Unemployment Rate rose in Q124 (to 3.8% from 3.7%)  hinted at a below-trend pace of Real GDP.  Traditional models relate the direction of change in the Unemployment Rate inversely to GDP Growth less trend.  Also, the fact that Total Hours Worked rose about 1.0% (q/q, saar) means that Productivity likely rose only slightly in the quarter (below the 2.0% consensus estimate).  Conceivably, bad winter weather may have been partly responsible for holding down output per worker and thus the low GDP pace.  The shift in jobs to low-productivity health care and government didn't help either.

There already were signs of a post-winter speedup in economic activity in March, particularly the rebound in the Nonfarm Workweek and Total Hours Worked (THW).  THW in March were 2.0% (annualized) above the Q124 average, a strong take-off point.  However, this week's April Employment Report is expected to show that this bounce-back is moderating.  Consensus looks for a slowdown in Nonfarm Payrolls to +210k m/m from +303k in March.  The estimate is lower than the +276k m/m Q124 average.   A steady 34.4 Hour Nonfarm Workweek and 3.7% Unemployment Rate, as consensus expects, also would argue for a moderation in a post-winter bounce-back.  Market friendly prints for Payrolls, Unemployment Rate and Workweek could outweigh a small speedup in AHE.

Coming to Grips With Powell's Comments

The stock market may continue to be weighed down this week as it comes to grips with Fed Chair Powell's comments.  He was disappointed in seeing three consecutive months of high inflation prints, ignoring the idiosyncratic parts of the March CPI.   As a result, the Fed's inflation target gets higher priority, requiring the need to delay rate cuts.

By also intending to keep the funds rate steady, the Fed appears to be relying on tighter financial market conditions to fight inflation.  Higher yields, weaker stocks, and a stronger dollar are meant to restrain economic activity, thereby holding down inflation.  Consequently, strong data are bad for the markets (implying more restraint is needed), while weak data are good (implying less restraint is needed) from this perspective.  In this regard, Thursday's release of Q124 Real GDP could present a problem.  The Atlanta Fed model's latest estimate is 2.9%, while consensus is 2.1%.  Both are above the Fed's 1.7-2.0% estimate of longer-run growth. 

Whether a weaker economy is needed may depend on whether inflation slows by itself.  A slowdown in the inflation trend would mean the Fed and markets don't have to restrain economic growth.  Steady Fed policy in the context of moderate economic growth and slowing inflation would again be a positive for stocks.

A slowdown in inflation by itself is conceivable.  The industry-specific reasons for the high CPI in March could ease if not reverse somewhat in coming months.  Housing rent could slow as well, as it catches up to the softening seen in private surveys.  Indeed, there is a chance for a surprise low inflation print this week.  Consensus expects a still-high +0.3% m/m in both Total and Core PCE Deflator for March.  The estimate appears reasonable and would not likely be a positive for the market.  But, a 0.2% print for Core can't be ruled out.

There are already tentative signs that the post-winter bounce in economic activity may be easing.  /1/ Initial Unemployment Claims have stopped falling while Continuing turned up a bit.  If they stay at the latest levels, they would suggest a slowdown in April Payrolls.   /2/ The Phil Fed Leading Index of Capital Spending edged down in April.  This should be seen in Durable Goods Orders within the next few months although this week's release for March may be too early.   /3/ Commodity prices possibly may have peaked.  Besides oil, some of the major commodity price indexes are off their recent highs. 

That Powell continues to push back the timing of rate cuts is not surprising.   Economic forecasts, as well as the theoretical idea that real interest rates will rise as inflation expectations fall, are highly tentative and bound to fail when the markets build in future policy.  Higher stocks, lower long-term yields and weaker dollar stemming from projected Fed rate cuts work to boost economic growth, thereby undermining the forecast.  Perhaps the Fed forecasted rate cuts to placate Congress and the Administration in this Presidential election year.  The idea may have been that promising rates cut in the near future would allow the Fed to hold policy steady through the election without being criticized for keeping policy too tight.   However, the built-in failure of this forward-announcing policy approach risks damaging the Fed's credibility.

 

 

The March CPI and Fed Policy

The stock market will likely shift its focus to the start of Q124 corporate earnings releases (which are likely to be strong and a market positive), as the Middle East situation appears to be stabilizing.  Oil prices will be an important monitor of the "temperature" in the region.  A decline would signal an easing in the region's tensions -- a positive for stocks.  Oil prices would need to stay high for awhile to have a significant impact on the US economy -- lifting inflation and hurting growth.   So, the Fed should also just watch the situation and not react to it.  Away from the Mideast, the Fed should think twice before changing policy intentions as a result of  the high March CPI.  The high print can be attributed to factors that are independent of aggregate demand or monetary policy.

The CPI measures price changes that could reflect inflationary pressures and/or relative price changes.  The latter results from factors specific to the demand/supply of an item and not an issue for monetary policy.   The culprits behind the higher-than-consensus 0.4% m/m increase in the Core CPI -- Motor Vehicle Insurance and Motor Vehicle Repair -- could be such industry-specific relative price changes.  If they had increased at the same rate as their prior 3-month averages, the Core CPI would have printed the consensus 0.3%.  If they were unchanged in March, the Core would have printed 0.2%. 

According to news stories, "extreme weather, driving habits and high repair costs" have been behind the sharp increase in auto insurance rates.  Motor repair costs have soared because /1/ modern cars are more complex, /2/ ongoing supply chain issues, /3/ shortages of trained technicians, and /4/ older cars need more repair work, made more important by the shift to used car sales.  These reasons suggest that at least some of the recently large increases in these components can be considered a result of factors specific to these industries. 

The jumps in Motor Vehicle Insurance and Repair in March could be one-offs and thus noise.  From a wider perspective, there always will be noise in the measurement of the CPI.  The real problem with the March Core CPI is that it would have been above the Fed's desired pace of 0.2% m/m even if these two components had risen in line with their recent trends.  

The Fed's goal is presumably to get noisy elements to push the CPI around a 0.2% m/m trend-line rather than 0.3%.  It's encouraging in this regard that more than half of the CPI components printed 0.2% or less in March.  However, it is still problematic that the largest CPI component, Owners' Equivalent Rent (OER), is trending 0.4%.  It may have to slow to 0.2-0.3% to lower the Core CPI trend to 0.2%.  This may happen yet, particularly if the CPI survey finally picks up the flattening in rent seen in private surveys.

There are two ironic aspects of OER: /1/ It is an imputed price, based on the CPI rent survey.  It measures what homeowners would pay if they rented their home.  Homeowners don't actually pay it.  This may be the reason why Fed Chair Powell highlights Core Inflation Less Shelter.  Why should the Fed restrain the economy for a price nobody pays?  /2/ Fed tightening can shift housing demand from ownership to renting, thereby pushing up rents.  So, it is questionable that Fed policy can do much to slow OER short of weakening the overall economy.  

With all the many specific factors impacting the components of the CPI and the largest component, OER, being more theoretical than real, Fed policy may do best by focusing on the broadest factor impacting prices -- labor costs.  So far, they appear to be in line with the Fed's inflation goal, taking account of productivity growth.  They argue for steady monetary policy at this point.  And, they keep open the door for Fed rate cuts if economic growth weakens.  

The Atlanta Fed model's latest estimate of 2.4% for Q124 Real GDP Growth is slower than the 3.4% Q423 pace -- which is a positive for the Fed but not weak enough to warrant rate cuts.  The questions now are the strength and duration of a post-winter bounce in Q224.  At this point, there is not enough evidence  to answer these questions.  So, Fed rate cuts remain hypothetical.

A Temporary Breather For Stocks

The stock market will likely continue to contend with higher oil prices and longer-term Treasury yields this week.  But, the rally could rekindle with the earnings season.

To some extent, the higher oil prices and yields are not entirely bad for stocks if, as is likely, a post-winter speedup in economic activity is a factor behind them.  They act like "built-in stabilizers" to restrain the latter, allowing the Fed to maintain steady policy through a possibly temporary bounce in the economy.  This week's US macro-economic data should keep policymakers in a wait-and-see position as well as keeping alive expectations of rate cuts ahead.  Meanwhile, the macro evidence suggest a strong Q124 corporate earnings season this month.

 March CPI

The consensus estimate of +0.3% m/m for both Total and Core CPI for March seems reasonable.  Both would slow from February's 0.4% pace.  The y/y would increase to 3.4% from 3.2% for Total and be steady at 3.8% for Core.   Oil-related energy prices (gasoline and heating oil) should slow, helping to hold down the Total.  (Seasonal factors offset most of the increase seen in gasoline prices at the pump.  So far, this offset is the case for April, as well.)  The Core CPI should not be boosted as much by airfares as in February, since seasonal factors provide less of a lift in March than they did then.  Most other components should be similar to their recent trends.  A slowdown in Owners' Equivalent Rent from 0.4% may be needed to push down the Core further.    

March Employment Report

The March Employment Report had more benign than worrisome components from the Fed's perspective.  Although Payrolls were strong, about half the increase was in non-economic sectors -- government and health care.  The sectors susceptible to monetary policy show the jobs slowdown desired by the Fed.  Nevertheless, the Nonfarm Workweek recovered back to trend, thereby pointing to a post-winter speedup in economic growth going into the Spring.   A steady Workweek in coming months would suggest the speedup is temporary.  

Other parts of the Report were benign.  The dip in the Unemployment Rate to 3.8% from 3.9% kept it above the 3.7% November-January level.  So, it still shows that labor market slack has increased.  This is also seen in the steady 7.3% U-6 Rate -- a broader measure of the labor market than the Unemployment Rate.  Perhaps thanks to the easier labor market conditions, wage inflation remains contained.  The 0.3% m/m increase in Average Hourly Earnings equals the 2023 average and Q124 average.  It is consistent with the Fed's 2% price inflation target, taking account of productivity growth. 

Q124 Corporate Earnings

Market participants look for about +3.0% y/y in S&P  500 corporate earnings for Q124, after about +8.0% in Q423.  The macroeconomic evidence suggest the risk is for a larger-than-expected gain.  Real GDP sped up on a y/y basis in Q124, oil prices reversed their decline, and economic activity abroad appears to have picked up while the trade-weighted dollar was flat.  Profit margins may have narrowed, however, as the Core CPI rose by less than Average Hourly Earnings.

                                                                                                                                     Markit
                                                                                                                                          Eurozone                        Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    PMI  
                [                                y/y percent change                                                   ]    (level) 

Q122            3.5                  63.4                +2.7                              5.4           6.4               57.8  

Q222            1.8                  60.9                +5.3                              5.3           6.0               53.9

Q322            1.9                  31.9                +9.0                              5.1           6.3               49.3

Q422            0.9                    6.7                +8.9                              4.9           6.0               47.1    

 

Q123            1.9                -19.5                 +3.0                              4.5           5.5               47.9 

Q223            2.4                -32.0                 +0.5                              4.4           5.2               44.7

Q323            2.9                -12.0                 -2.5                               4.3           4.4               43.2

Q423            3.1                -12.0                 -2.5                               4.3           3.9               43.8

 

Q124            3.2                 14.0                   0.0                               4.3           3.8               46.3                                              

                                                                           

* Based on the Atlanta Fed Model's latest projection of 2.5% (q/q, saar).