A Friendly FOMC?

The stock market may resume its rally this week, as the Israeli-Iran attack may move to the background at least for now and the Fed becomes center of attention.  There is a possibility the Fed may begin to tilt toward an easing at this week's FOMC Meeting.  This could be seen in the Statement as well as in Fed Chair Powell's post-FOMC news conference.  

The FOMC Statement might tone down its description of inflation, given the low CPI prints of the past two months.  In May, the Statement said, "Inflation remains somewhat elevated."  Perhaps this remains true for the Core PCE Deflator on a y/y basis, but not the Total PCE Deflator (see below).  The Statement also might modify its description of the balance of risks.  In May, it said it "judges the risks of higher unemployment and higher inflation have risen."  Tariff-related risks to both remain, but the evidence is building towards the former rather than the latter

The Fed is in a delicate situation with regard to monetary policy.  The latest evidence of slowing inflation and possibly slowing economic growth opens the door for rate cuts at some point.  However, a Fed shift in that direction risks the impression of bowing to political pressure from Trump.  To be sure, even a hint that the next move will be an easing could elicit a complaint from Trump that the Fed is dragging its heels.  And, it is likely that any hint would probably be balanced by tariff-related uncertainty.  Still, any hint of easing would be a market positive.

The US economy appears to be evolving along the lines of, if not better than, the Fed's Central Tendency Projections made in March (see table below), which embody expectations of 1-2 rate cuts in H225.  Real GDP Growth in H125 is 1.8%, assuming the Atlanta Fed Model's latest projection of 3.8% for Q225 (after -0.2% in Q125).  The 1.8% H125 average pace, which smooths out weather and other temporary effects, matches the Fed's estimate of the longer-run trend in Real GDP.  Meanwhile, inflation is behaving better than expected by the Fed.  April's y/y is 2.1% for the PCE Deflator and 2.5% for Core -- both below the Central Tendency Forecasts.  Powell may bite the bullet and recognize the desired behavior of the US economy and what it implies for monetary policy.  

                                      Fed's Central Tendency Projections for 2025 (Q4/Q4 % Change) 

 Real GDP Growth                  1.5-1.9      

PCE Deflator                           2.6-2.9  

Core PCE Deflator                  2.7-3.0 

Evidence pointing to a slowdown in economic growth from the Q225 pace is building.  Initial and Continuing Unemployment Insurance Claims have climbed over the past three weeks.  The latest week's Claims data are above their respective May averages.  This week's US economic data could add to this evidence.  In particular, consensus looks for a slight 0.1% m/m increase in May Ex Auto Retail Sales, the same as in April.  Not too much should be made of a soft print, since it could be attributed to the typical pause after a strong month (March).  Nevertheless,  it would keep open the door for slower growth ahead.  In contrast, a large gain could bolster expectations of a sustained strong pace of economic activity. 

  

 

Inflation Next, Growth and Federal Deficit in Background

The stock market may continue to rally this week, as US inflation data are expected to remain contained despite the beginning impact of tariffs and a post-winter rebound in economic activity.  Controversy over Trump's tax bill should bubble in the background, with a self-imposed passage deadline of July 4.

Consensus expects a moderate May CPI, with Total up 0.2% m/m and Core up 0.3%.  This month's report should begin to pick up the pass-through of Trump's tariffs to prices.  However, other forces are at work, as well, including subdued oil prices, compositional shifts in demand for goods and services, and contained wage inflation.  In particular, all three factors and seasonal factors could depress airfares again, as they did in the prior two months.   Also, housing rents may be finally reflecting the softness seen in private surveys months ago.  So, a lower-than-consensus May CPI can't be ruled out.

The May Employment Report confirmed a post-winter rebound in economic activity in Q225 but left open the door for slower growth in Q325.  Total Hours Worked (THW) in May stood 2.4% (annualized) above the Q125 average, markedly better than the +0.7% (q/q, saar) pace in Q125.  This is consistent with the Atlanta Fed Model's latest estimate of +3.8% (q/q, saar) Real GDP Growth in Q225, assuming a boost from productivity.  However, THW in May were only 0.2% (annualized) above the April-May average.  Unless there is a bounce in at least one of the next few months, THW could slow sharply in Q325.  The still-high level of Unemployment Claims for the second week in a row supports this possibility.

The Employment Report also showed that wage inflation remained in its recent range.  Although Average Hourly Earnings ticked up to 0.4% in May, this followed a low 0.2% in April.  The April-May average is 0.3%, equal to the recent trend.  And, the uptick in the unrounded Unemployment Rate to 4.24% from 4.19% suggests upward pressure on wages remains modest.  The question ahead is whether tariff-related boosts to prices lead to a ratcheting up in wage demands as labor tries to recoup its purchasing power.

There are two aspects of the Federal Deficit debate that are relevant for the markets.  One is the sequential change in the Deficit.  The other is the longer-run sustainability of US debt, that is whether investors -- domestic and foreign -- will want to hold the debt around the current level of interest rates.   

A sequential decline in the Federal Deficit would hurt US economic growth.  There would be a substantial drag if the 2017 tax cuts are not extended.  Cuts in Federal subsidies and transfer payments would hurt growth, as well.  An extension of the tax cuts would have little impact on growth, as there would be no increase in fiscal thrust.

The longer-run sustainability of the Federal Deficit has been an issue forever.  So far, the US economy has not collapsed as a result.  Continuing Federal Deficits have been possible because the US dollar is the most important global currency and foreigners need it, either for transactional or storage purposes.  

Investors have been willing to hold US debt and other assets, in part because of a reliable legal system, respect for property rights, and a government constrained by checks and balances in the US.  If investors lose faith in US institutions or policies, then the huge amount of outstanding debt will be a problem.  The sale of US assets -- stocks, bonds and currency -- would push the US economy into recession.  It's not clear the Fed would be able to withstand it if the magnitude of selling is large.  So, while cutting the Federal Deficit would likely be viewed positively by the markets,  if it is not, doomsday prognoses are probably overdone as long as US institutions remain highly respected.  The Fed's independence is one such institution that needs to be maintained.

 

 

   

 

 

  

The Economic Picture In The Background

The stock market is likely to continue being pushed around by positive and negative developments in the tariff war.  Nevertheless, the market still has its eye on the economy in the background, looking for evidence that the tariffs, either themselves or uncertainty surrounding them, damage growth prospects.  This week's key US economic data are not expected to provide such evidence,  Both the May Employment Report and Mfg ISM are seen indicative of moderate economic growth.  So, the macro background is still supportive of stocks.

Consensus looks for a slowdown in Nonfarm Payrolls to +130k m/m in May from +177k in April.  The expected May pace would be consistent with a steady 4.2% Unemployment Rate, which is the consensus estimate.  Such a level of unemployment is historically low but shows some slack relative to last year.  And, as Fed Chair Powell has said, there is little evidence that wage gains have generated inflationary pressures.  That is, a wage-price spiral is not evident.  The consensus estimate of +0.3% m/m for Average Hourly Earnings is consistent with the Fed's 2% inflation target, taking account of trend productivity growth.  The y/y would fall to 3.7% from 3.8% if consensus prints.

The Claims data support the idea of a slowdown in May Payrolls.  Both Initial and Continuing have trended above their levels in the April Payroll Survey Week, suggesting a pickup in layoffs and softening in hiring.  Both jumped in the latest week, but more weeks at the higher levels are needed to confirm their  import.

The consensus estimate of a steady 48.7 for the May Mfg ISM would be consistent with sluggish but non-recessionary growth in the manufacturing sector.  It would remain below the 50.1 Q125 average.  This sector is particularly vulnerable to the tariff war, impacted by higher input costs and potential loss of export markets.  To be sure, the weaker dollar could have helped some industries,

The Atlanta Fed Model's latest projection of Q125 Real GDP Growth is a strong 3.3% (q/q, saar).  The strength largely reflects the drop in April Imports.  This is a mirror image of what happened in Q125, when a surge in imports pulled down Real GDP to -0.2%.  Both figures likely reflect measurement problems when there are large swings in imports.  The best way to evaluate recent GDP Growth is to average the two quarters.  Using the latest Atlanta Fed Model estimate, Real GDP Growth in H125 is about 1.5%.  This is close to the longer-run trend estimated by the Fed and is not an inflationary pace.   

A Tariff Threat and House Bill -- Market Problems?

The stock market may brush aside Trump's apparently "shoot from the hip" tariff announcements after he postponed his latest tariff threat to the EU.   His initial threats appear to be for shock value, to be restrained by his advisors afterwards.  They seem to have a "transactional" goal in mind.  Whether his new July 9th deadline results in a deal or not, it is far enough away for the issue to move to the back burner for the market for now. 

Meanwhile, the House tax bill appears to be fairly neutral for the economy and stock market.  Most of the provisions just make permanent tax provisions that have been in place since 2017.  So, there is little net fiscal thrust from them.  Instead, the cuts to some entitlement programs are a drag on aggregate demand.  And, new spending projects, like "Golden Dome," run into the same problem as Trump's desire to re-shoring manufacturing production from abroad -- other spending would be "crowed out" while the economy is operating near full capacity.   This would be accomplished through higher inflation and Treasury yields, stronger dollar, and/or lower stocks.  In any case, it is still a work in progress, with the Senate expected to make some changes to it.

The possibility of inflationary pressures from Trump's initiatives is a potential negative for stocks, kept in play by longer-term Treasury yields staying high.  To be sure, there could be relief if it turns out that re-shoring or building a defensive system takes a long time to build, so the pressure on resources does not show up quickly.   

There could be relief this week as consensus expects soft prints for this week's US economic data.  Consensus sees flat April Durable Goods Orders Excluding Transportation, after -0.4% m/m in March.  Uncertainty about Trump's tariffs could continue to weigh on them for a few more months.  April Personal Spending is expected to slow to  +0.2% m/m from +0.7% in March -- a pause from a strong post-winter bounce.  And, the April Core PCE Deflator is seen at a low 0.1% m/m, in line with the June CPI.  Boosts from tariffs are likely to begin to be seen in the May CPI, due in June.

 

Focus on Federal Deficit, But Stronger US Economic Growth Ahead?

The stock market may focus on Congressional efforts to forge a budget, now that Moody's downgraded the US because of the unchecked outlook for the federal deficit.  With the House Budget Committee failing to agree on a budget last week, the question is whether or how will taxes be raised or federal spending cut.  Trump presumably will weigh in on the deliberations.  From the stock market perspective, the best outcome would likely be skewed toward spending cuts and a reduction in the 10-year projection of the federal deficit.  Indeed, the Moody's downgrade could be viewed a market positive for putting pressure on Congress to cut the deficit.  Nevertheless, budget-related flareups in the stock market never last.  So, a pullback is probably a buying opportunity.

Once the budget issue is resolved,  stocks may be supported by expectations of stronger economic growth ahead.  Increased business investment and net exports, along with a shift away from imports to domestic production, may turn the consensus outlook away from recession.  In such a turn-about the market may begin to consider a tightening as the next Fed policy move.  Whatever the Fed's next move, it will not likely be an imminent risk until late this year if at all.  

The fear of recession stemming out of Trump's tariffs has abated since he pulled back on the bulk of Chinese tariffs.  There will be less of a tax on consumers than what was feared.  Moreover, the re-shoring of production by companies and the planned investments in plant and equipment to do so will boost economic activity ahead.  And, US exports will be helped by Trump's deals with other countries, such as the 210 Boeing plane order by Qatar, as well as by the recently softer dollar in the FX market.

These boosts to economic activity may not fully boost GDP.   They could "crowd out" other sources of demand, if, as is case now, the US economy is operating close to full capacity.  Higher longer-term yields would weigh on housing and other interest-sensitive spending.  Higher inflation would hurt the consumer.

One US economic data release that could become important to watch is Durable Goods Orders.  (April Durable Goods Orders will be released May 27.)   They contain information regarding capital spending.  It may take several months before they show a pickup in the latter, since the uncertainty and recession fears stemming from Trump's initial tariff announcements likely had businesses pull back in a wait and see posture.   A leading indicator of capital spending in the Philadelphia Fed Manufacturing Survey points to a softening in capital spending into the summer before a rebound.

Construction Spending, typically not given much attention by the markets, will contain information on factory and warehouse building.  These could be a catalyst for growth, as well. 

Another important economic data release will be the Trade Deficit.  A positive for the US economic outlook would be a speedup in exports and a slowdown in imports.  This will be difficult to judge, since both exports and imports surged in Q125 in anticipation of tariffs here and abroad.  In 2024, exports rose 2.4% while imports rose 12.2%.  In Q125, exports rose 4.6% and imports rose 14.9%.  There could be a pullback in both toward longer-term trends in the next quarter or two.

A move toward closing the door on foreign competition, which is what tariffs do, could have an indirect effect on inflation.  By shielding US workers from having to compete with lower-paid foreign workers, US labor may increase their wage demands.  Fed officials, including Powell, have attributed the benign wage inflation despite lower unemployment to the Fed's success in holding down longer-term inflation expectations.  However, it also could have been a result of competition from low-cost labor abroad.  And, if the latter eases up, wage inflation may pick up.

 

 

 

 

 

 

 

 

Tempered Tariffs?

The stock market may continue to be buoyed this week by talk or reports of more trade deals and a cut in Chinese tariffs.  They suggest the bite from tariffs may be less than the worst feared.  To be sure, this weekend's US/China negotiations need to have gone well.  The slew of US economic data this week may be taken in stride, as they could be too early to show the tariffs' impacts.  

The UK trade agreement and Trump's expected backtracking of Chinese tariffs still leave tariffs in place, with their threat of higher US inflation and slower economic growth.  However, both should temper the extreme concerns expressed by some regarding the fall-out from the tariffs.  Indeed, Fed Chair Powell said in his post-FOMC news conference that tariff negotiations could result in a smaller-than-expected boost to inflation.  If the fall-out turns out to be modest, it would probably be seen by late summer or fall.  By then, the fall-out would likely have to be pitted against the federal spending and tax cuts now being considered in Congress.  If the bulk of the tax cuts just extend current law, their impact on the economy could be modest, as well.  In this case, the Fed may not have a compelling economic reason to change policy.

Most of this week's US economic data are for the month of April, when some of the tariffs may have just begun to hit.  The consensus estimates for the April CPI appear to reflect this possibility, as both Total and Core are seen rising 0.3% m/m after the low March prints (-0.1% Total and +0.1% Core).  There is a risk, however, that consensus is too high, as some of the reasons for the low March prints may recur in April, particularly the decline in Airfares. Although the Manheim Survey shows a jump in Used Car Prices in April, these are at the wholesale level and tend to be seen in retail prices with a lag.  

Consensus looks for modest economic growth-related data -- April Retail Sales, Industrial Production and Housing Starts/Permits.  A slowdown could reflect drags from the tariff threat, but not necessarily.  Retail Sales are expected to slow to +0.1% m/m Total (versus +1.5% in March) and +0.3% Ex Auto (versus +0.6% in March).  This could be the typical easing after strong prior gains, so should not be viewed with concern.  A stronger-than-consensus print can't be ruled out, nonetheless, as anticipatory buying ahead of the tariffs could have extended into this month.  Industrial Production is expected to edge up 0.1% m/m after +0.3% in March.  The risk is for a decline, based on Total Hours Worked in Manufacturing last month.   Consensus also looks for little change in April Housing Starts/Permits, which, in the 1.3-1.45 range, have been well below the 1.6 Mn Unit level needed to supply long-term demand.

Unemployment Claims data remain important to watch.  The latest data show an unwinding back to trend of the prior week's jumps in Initial and Continuing (suggesting the latter resulted from a technical factor).  Powell mentioned that the Claims data remain low, indicative of a strong labor market.  Powell also downplayed the -0.3% (q.q, saar) dip in Q125 Real GDP, blaming it on the difficulty of capturing the large swing in imports.  An unwinding of the import surge could result in a bounce in GDP in Q225 or Q325.  The Atlanta Fed Model latest estimate of Q225 Real GDP Growth is +2.3%.

 

 

 

Stock Rally To Continue?

The stock market may continue to rally this week, as resolution of the tariff issue appears to be moving ahead.  The market is likely to become more focused on the fall-out from the tariffs.  There are two questions:  /1/ What is the direct boost to inflation and hit to economic activity? /2/ Will the direct hits develop into a wage-price spiral and/or recession.  It will take time to answer them.  So, the questions should be more in the background for awhile.

The direct hit to prices from tariffs begin mostly in May.  While there should be a lot of anecdotal evidence regarding their impact on prices, the May CPI will be released in June.  Meanwhile, the April CPI, due May 13,  risks being benign, held down by the pass-through of lower oil prices and anticipatory price cutting by motor vehicle companies.  The April Employment Report shows that wage inflation remains subdued, which should help hold down the CPI, as well.

The April Employment Report also suggests that economic activity was set to bounce back in Q225 ahead of the tariffs.  The +177k m/m increase in Nonfarm Payrolls exceeded the +164k 2024 average.  Total Hours Worked in April were 2.0% (annualized) above the Q125 average, a speedup from +0.8% (q/q saar, revised up from 0.5%) in Q125.  The jump in Initial and Continuing Claims in the last week of April, however, raised the risk that the bounce-back will be short lived.  To be sure, it is somewhat suspicious that both Initial and Continuing jumped in the week.  Continuing tends to lag Initial.  Some technical factor may have been behind both jumps.  So, their higher levels have to confirmed in this week's release.

The -0.3% dip in Q125 Real GDP also looks suspicious, since most of the weakness was in a surge in imports ahead of the tariffs.  It would seem reasonable that most of the surge should have found its way into inventories.  (To be sure, some of the import surge fed into business equipment spending, part of which is calculated directly from net imports.)  While inventories were up a lot, the surveys from which they are measured may not have picked up all of them.  It remains to be seen whether inventory investment gets revised up significantly.  If not, it wouldn't be the first time that sharp changes in Net Exports had questionable impacts on GDP.

So far, the Payroll data do not show a significant number of job cuts in the federal government.  They fell 9k in April and down 26k since January.  One reason is that the 75k workers who are receiving ongoing severance pay are counted as employed.  There should be a large drop in Federal Government Payrolls once their severance pay ends.

 

  

Spring Rally?

The stock market may continue to move up, now that Trump appears to have pulled back from undermining Fed Chair Powell and Treasury Secretary Bessent suggested the trade war with China will de-escalate soon.  Besides keeping an eye on whether these shifts in fact occur, stocks are likely to re-focus on the US economy.  Evidence of moderate or strong growth and low inflation will be positive, as it would suggest the economy could avoid recession after the tariffs hit.

This week's key US economic data should not stand in the way of further stock market gains.  Despite an expected a flattish Q125 Real GDP and modest April Employment Report, the latter's details would point to a speedup in Q225 Real GDP Growth.  And, inflation-related data are expected to be subdued. 

Q125 Real GDP is expected to be soft.  Consensus looks for a slowdown to +0.4% (q/q, saar) from 2.3% in Q424 while the Atlanta Fed Model projects -0.4% (ignoring its -2.5% projection that incorrectly includes the impact of gold imports).  There are several possible reasons for a slowdown:  /1/ Bad weather in January and February whose impact was not fully offset in March, /2/ Lagged drag from the tight level of monetary policy, /3/ cautious behavior of consumers and businesses ahead of Trump's tariffs and government firings, and /4/ drag from the stoppage of illegal immigration.  The first explanation is the one with the most potential to reverse in Q225.    

If Q125 Real GDP surprises on the upside, the market may quickly discount the strength if it stems from a jump in inventory investment.  The latter would be viewed as temporary.  However, the inventory buildup most likely would consist of imports brought into the country ahead of tariffs.  So, any unwinding of inventory investment in Q225 would probably be matched by an unwinding of imports -- with little net impact on GDP.   

The April Employment Report will offer a picture of the economy's strength in early Q225.  If consensus is right, the jobs report should point to a speedup in Q225 Real GDP Growth. 

Payrolls are expected to be on the soft side, however.  Consensus looks for them to climb 130k m/m, after a post-winter bounce of +228k in March.  Payrolls averaged 152k m/m in Q125 and 168k m/m in 2024.  Despite the expected slowdown in job growth, the Unemployment Rate is seen remaining at 4.2% and the Nonfarm Workweek flat at 34.2 Hours.  If consensus prints, and there are no revisions to prior months, Total Hours Worked in April would stand 1.5% (annualized) above the Q125 average.  THW rose 0.5% (q/q, saar) in Q125.  So, THW would point to a speedup in Q225 Real GDP Growth. 

Other key US economic data this week could temper expectations of the magnitude of a speedup, based on consensus estimates.  Consensus looks for a dip in the Mfg ISM to 47.9 in April from 49.0 in March and 50.1 in Q125.  It would be the second consecutive m/m decline, but remain at a non-recessionary level.  Hard data on manufacturing indicated modest growth in March.  

This week's inflation-related data are expected to be subdued.   Consensus sees April Average Hourly Earnings contained at a modest 0.3% m/m.   The Q125 Employment Cost Index (ECI)  is seen rising 0.9% q/q, the same as in Q424.   Both Average Hourly Earnings and the ECI have had a fairly steady pace recently (see table).  The y/y for both is just under 4.0%, consistent with 2.0% price inflation if underlying productivity growth is about 2.0%.  

Consensus looks for a slight  0.1% m/m increase in the March Core PCE Deflator, in line with the low Core CPI print.  Note, however, tariffs on Chinese goods are already hitting consumer prices in the US, according to news reports.  Their impact will presumably be seen in the April and May CPI.

                             (q/q percent change)

                          AHE                        ECI 

Q125                0.9                            na

Q424                1.0                           0.9                                                

Q324                0.9                           0.8    

Q224                1.0                           0.9                     

Q124                1.0                           1.2                     

Fed Policy, Treasuries and Tariffs

The stock market should continue to be subject to developments in the tariff situation, including commentary about the tariffs' impact in corporate earnings reports.  Although Fed monetary policy is now on hold, officials too will be focused on the potential drag on economic activity and boost to inflation from tariffs.  Besides Fed policy, the risk of massive selling of longer-term Treasury securities is not independent of tariff developments.  In the background, Trump's attack on Powell could develop into a big problem for financial markets.

Fed Chair Powell commented last week on the framework the Fed will use to decide on monetary policy once it sees effects of the tariffs.  He said whether to tighten or ease will depend on how far each of its mandated targets -- unemployment and inflation -- is from its goal and how much time each would be expected to take to return to goal.  Presumably, policy would be focused more on the target that is slower to return.  Powell said the tariffs may push the targets away from their goals for the "balance of the year."  He also underlined the importance of restraining inflation expectations.  Currently, the Fed is in no hurry to change policy.  As I mentioned last week, the optimal solution to this quandary is to let the unemployment rate rise at first and then ease policy.  This would allow the economy to recover without putting upward pressure on wage inflation. 

Powell did not discuss whether loss of confidence in the US will result in massive selling of Treasury securities, most likely because it is not in the Fed's purview.  However, it remains a potential problem for stocks and the economy.  The possibility of significant confidence loss is not independent of tariff policy.   On the one hand, a winding down of the tariff issue, perhaps by Trump's paring down the size of tariffs for those countries with which there is successful negotiations, could restore confidence in the US and end the dumping of Treasuries.  This would likely result in a decline in longer-term Treasury yields and stronger dollar -- a double positive for the stock market.  On the other hand, a worsening in the tariff situation could prompt greater loss in confidence and more Treasury/dollar selling -- a double negative for stocks. 

Trump's complaint that the Fed should ease and that Powell should be fired would probably backfire if carried out.  Both would be viewed as /1/ inflationary and /2/ undermining Fed independence.  They would result in higher longer-term yields and weaker dollar -- negatives for the stock market.  Trump cannot legally remove Powell as Fed Chair while his term lasts through May 2026.  This, however, may not stop Trump from trying, as his staff is reported to be looking into how he might be able to fire Powell.  A soft Q125 GDP report, due April 30, could raise the pitch of Trump's tirade.  His attack on Powell appears to be an attempt to shift the blame for the financial market sell-offs and economic slowdown to the Fed from tariffs. 

 

 

 

 

Stocks Range Bound?

The stock market may stay in a range near term, helped by some easing in the tariff situation but hurt by higher longer-term Treasury yields and weaker dollar.

The worst of the tariff situation may be over.  China has said it will not retaliate further.  And, headlines could turn market-positive as bi-lateral negotiations with other countries occur.  Also, the Administration's idea regarding natural gas exports could resolve the situation positively.  The next positive surprise could be if China and the US agree to talks to diffuse the issue.  However, until then the impact of the large tariff on Chinese goods remains to be seen. 

The sell-off in Treasuries and the dollar, however, could become a major problem for stocks.  It may show waning demand for US assets stemming from bad tariff policy by the US.  Or, it could result from higher inflation expectations, also stemming from the tariffs.  The latter is seen in the jump in 5-year inflation expectations in the University of Michigan Consumer Sentiment Survey to 4+% from the former 3% trend.  The jump in longer-term inflation expectations runs counter to the Fed's idea of a one-off impact of tariffs on prices.  The Fed may be forced to tighten at some point as a result of these market moves.

In contrast to these fears, the US economy so far remains solid with little inflation.  Unemployment Claims stayed low in early April.  Inflation also is not problematic.  Ironically, the low March CPI in part reflected large price cuts that might have resulted from a tariff-induced pullback in demand in -- airfares and hotel rates.  The direct boost from the tariffs is yet to be seen.  There is no reason from these fundamental data for the Fed to change its steady policy stance.

Here are some thoughts on the trade deficit and tariffs.

 Explaining the Trade Deficit -- Several Ideas

1.  Trump pushes this idea: The deficit results from unfair practices of US trading partners.  These include subsidizing exports, dumping products and manipulating currencies.  These practices should be addressed, but universal, high tariffs would seem to be excessive as the unfair practices are likely concentrated in only a few countries and can be addressed with more targeted policy tools.  

    a.  China is the major perpetrator.  Their actions stem in part from central planning, for which the typical result is overproduction relative to demand.  China dumps the excess supply onto the rest of the world, depressing prices and undercutting manufacturing in other countries.  Many economists have argued that China should boost its domestic demand, in part by structural changes. 

2.  Some economists blame the US for the deficit.  They say the deficit results from inadequate saving, that is excessive consumption, by the US.   Their argument is based on an identity in GDP accounting that equates national saving to the trade balance.  A trade deficit equates with a saving shortage.  There is almost a moral criticism in this explanation.

3.  A third explanation:  The deficits result from the desire of other countries to hold US dollars.  Financial inflows lift the dollar in the FX market, thereby hurting exports and boosting imports. Countries are willing to produce for the US in exchange for paper debt.  The deficits can be interpreted as compensation to the US for having a global currency with a dependable legal system behind it.  The current sell-off in Treasuries and dollar raise the possibility that this cause of the trade deficit is ending.

Trump's tariffs address the first two explanations.  The reciprocal tariffs are supposed to be geared to unfair trade-related actions of each country.  And, as a tax, they result in forced saving by the US.  Even if these are viewed as justifiable reasons to cut the trade deficit, the magnitude of the tariffs remains an issue.

If Trump viewed the trade deficit the third way, he'd likely see it as a good deal -- an exchange of paper for goods and services.

From the perspective of the third explanation, eliminating the trade deficit through tariffs could lead to a dollar shortage.  This would strengthen the dollar in the FX market, offsetting the impact of the tariffs and leading to a renewed US trade deficit.  However, it could result in other currencies playing a larger role in international trade and finance, pushing down demand for dollars and hurting the US position in the world economy.  The current weakness of the dollar in the FX market and increase in Treasury yields could be anticipatory of this scenario.

Is Elimination of the US Trade Deficit With Tariffs a Good Goal?  

1.  Good Goal:  Labor unions think so because fewer imports could shield them from competition with the global labor force. To be sure, although their members could bargain for higher wages, they would be hurt by higher prices on goods and services they consume as well as by a recession if precipitated by tariffs.  

2.  Good Goal: Cutting the trade deficit would slow the move of the US into being a net debtor.  By going into debt to the rest of the world, the US provides other countries with the means to buy US assets.  Part of US production then would go to foreigners as dividends, profits or interest.  The US would be working in part for others, not a good outcome.  However, foreign purchases of US assets could be controlled by Presidential or Congressional actions, so a general tariff may not be necessary.

3.  Good Goal: Re-shoring production could make the US less vulnerable in a political or military conflict.

Bad Effects of Eliminating the Trade Deficit With Tariffs

1.  The US standard of living will decline if the deficit is eliminated by cutting imports.  The standard of living had been propped up by the amount of the trade deficit, which represents the amount the country spent beyond its income.  

2.  The tariffs' role as a tax would be behind the decline in the standard of living.  

2.  Replacing the international supply nexus with a domestic system would be costly to implement.  

3.  Once implemented, a domestic system would be more costly to operate than the international supply nexus, otherwise it would have been in place already.

4.  The range of goods available to US consumers could shrink, as some goods become too expensive to market. 

 Exporting Natural Gas

1.  The Administration has raised the possibility of substituting other countries' purchases of US natural gas for tariffs as a way to eliminate the trade deficit.

2.   Boosting exports of natural gas instead of cutting imports by imposing tariffs would eliminate the tariff's bad effects.  And, it would boost US GDP. possibly with little strain on the labor market.

3.  It would eliminate the benefits from reducing foreign competition for unions and moving the US further into a net debtor position. 

4.  It would likely lift natural gas prices.

A Little Appreciated Benefit of the Trade Deficit

1. The aging US population means that more working-age people will be needed to support the country's standard of living.  Immigration is one solution.  However, Trump's anti-immigration policy closes that door.  Running a trade deficit allows the US to take advantage of working-age people abroad without incurring the costs associated with immigration. 

 

Trump Tariffs Still A Problem, But...

The stock market and other financial markets are setting up for their fears of what may stem from Trump's tariffs -- recession and the costs of major shifts in the global economy.  However, it will take time to determine how the fall-out from the tariffs plays out, as discussed below.  So, the market sell-off may become excessive if the worst of the fears don't happen, and some recovery near term is possible.  This week's release of the March CPI could help, as it risks being soft (consensus is 0.1% m/m Total and 0.3% Core, which can't be ruled out but risks being too high).  To be sure, an end of the sell-off may require the stock market to overshoot and hit an important support level.  Or, the market may find relief if there is movement by countries to negotiate with the US. 

1.  Tariffs as a Tax on the Consumer

Expectation of a recession stems from the role of tariffs as a tax on the consumer.  Assuming full pass-through of the tariffs to prices and no change in spending composition, Trump's tariffs would cut consumers' purchasing power by $1Tn per year, including the tariffs on steel, aluminum and autos, according to news services.   This represents about 3.5% of GDP, making it the largest tax hike relative to GDP since 1942 .   

The drop in Real GDP would be less under some scenarios.  /1/ If people reduce their saving rather than spend and pay the higher prices.  /2/ If people shift the composition of their spending toward domestically-produced goods and away from imports.  /3/ Other countries cut their exports or their prices to the US.

2.  Prices of Domestically-Produced Goods

The drop in Real GDP could be worse if domestic producers lift their prices, taking advantage of weakened competition from imports.  Price hikes by domestic producers would eliminate the ability of consumers to avoid paying the tariffs by shifting the composition of their spending.  The hikes by themselves would cut consumer purchasing power (and boost the companies' profits), as well.  So far, however, a couple of domestic auto companies have cut prices temporarily.  One auto company is holding prices steady at this point.  

3.  Shift in Demand to Domestic Producers

A shift to domestically-produced goods, as apparently some auto companies have begun to do, not only could allow consumers to avoid paying the tariff, it would boost GDP.  At the extreme, there would not be a recession but instead stronger economic growth.  The problem then would be that the increased domestic production would have to displace other domestic production if the economy is operating near full capacity (as it is now).   In particular, demand for labor could climb and exert upward pressure on wage inflation.  Higher interest rates, weaker stocks and higher inflation are ways the markets would accomplish the "crowding out."  When the economy is operating at full employment, the eventual outcome would be the same level of GDP as what would have been the case without the tariffs, but the composition of output would differ.

4.  Retaliation

Some countries already have responded to the tariffs by imposing their own.  Anger at the US reportedly has prompted Canadians to cancel travel to the US, which is a reduction in US services exports, and to impose tariffs on some US motor vehicles.   China is about to impose tariffs on US goods.  It also has retaliated by limiting sales of rare earth minerals.  The next shoe to drop could be the European Union, although some European countries (eg Italy and Ireland) appear to be arguing against or for modest retaliation.  Vietnam appears to be moving in that direction, as it has offered to drop all its tariffs on US goods.  Note that dropping its tariffs may not be enough to placate Trump -- Vietnam controls its currency and may be holding it down relative to the dollar.

5.  Price Inflation

There are several ways that tariffs could precipitate higher price inflation.  /1/ A pass-through of the tariffs, /2/ matching price hikes by domestic producers, /3/ shortages created by other countries'  retaliatory actions,  and /4/ higher wage inflation resulting from increased demand for labor or from a push by labor to catch up to the higher prices.  

These channels may take time to work through.  So, inflation measures, like the CPI and PCE Deflator, could have high prints for a number of months, even if the pass-through is one-off as the Fed thinks is likely.  A full pass-through of the tariffs would boost the PCE Deflator by 5%.  Wage inflation will be important to watch.  A speedup in wages would suggest that a "wage-price spiral" is a more likely consequence of the tariffs than the one-off idea.

6.  Fed Policy

The Fed will eventually cut rates to fight recession, but may be slow to do so while inflation stays high.  The Fed would manage both issues well by first letting the economy weaken and unemployment rise and then easing to end the recession.  Creating labor market slack initially would allow the economy to resume growing without boosting inflation.

7.  Fiscal Policy

Trump may be hoping that an extension of his earlier tax cuts will offset the drag from tariffs.  However, the extension shouldn't be viewed in the way done by the Congressional Budget Office (CBO).  The CBO measures it against a baseline where the tax cuts are allowed to expire.  Doing so, CBO estimates the extension would cost $4.6 Tn over 10 years.  This is the 10-year sum, not the annual amount.  In terms of offsetting the tariffs, however, it is the sequential change that matters.  And, a simple extension would add zero sequentially.  So, it would not offset the drag from tariffs.

 

 

Fear of Fall-Out from Trump Tariffs

The stock market may continue to be fearful of the fall-out from Trump's tariffs, with the big announcement of reciprocal tariffs on April 2.  At this point, the fear is that economic growth and corporate earnings will be hurt, while inflation will speed up.   This week's key US economic data may be viewed as too early to indicate any tariff effects.  The market may get clarity on individual company impacts during the Q125 earnings season in April. 

Overall, Trump's intention appears to be to bring manufacturing production back to the US from abroad.  While the economy is operating close to full capacity, this result would likely be accomplished through a shift in resource allocation rather than by higher-than-otherwise overall activity.  To some extent, cutbacks in government jobs and spending free up resources for this purpose.  The markets could move in ways to accomplish it, as well.  For example, higher interest rates would depress construction activity and higher prices would depress consumption.  At the end, overall GDP would be about the same but the composition different.

The 25% auto/truck tariff may not hurt domestic motor vehicle manufacturers as much as feared.  They would capture market share as sales shift from imports to their less expensive cars and trucks.  Raising prices could help profits, as well, but it would have to be balanced against losing unit sales as a a result.  This could be an important restraint on price hikes, as the "price elasticity" of vehicle demand is estimated to be high (see below).

The companies' profitability would be hurt, however, if the higher costs of parts can't be passed through to prices fully.  For example, the company that uses imported parts the least presumably would raise prices the least. This could exert competitive pressure on other companies, dissuading them from passing through the full increase in costs.   Trump's warning to domestic producers not to take advantage of the tariffs to raise prices also could weigh on pricing decisions.  In contrast, auto companies might be able to cut other costs of production that offsets the effect of the tariffs at least in part. 

There may be some unintended consequences, as well.  /1/ From a macro perspective, an increase in demand for labor could boost wages and thus price inflation beyond the initial impact from the tariff.  This result could necessitate tighter monetary policy.  /2/ The tariffs could shift resources into "old" industries, hurting the ability of "new" industries, such as robotics, to expand profitably.  /3/ The tariffs could help the environment by reducing demand for motor vehicles.  However, an increased use of older, less efficient vehicles could worsen it.

Here is some background information regarding how tariffs may impact demand for motor vehicles:

Price Elasticity:  This figure shows the percentage change in demand for a one percent change in price.  The smaller the price elasticity of demand for vehicles, the smaller the decline in vehicle demand from a pass-through of the tariffs to prices. An extreme example would be completely inelastic demand.  In this case, there would be no decline in vehicle demand for a full pass-through of the tariff.  

The consensus estimate for the price elasticity of motor vehicles is about -1.0.  This means that a 1 percent increase in price results in a 1 percent decline in demand.  The price elasticity is higher for lower-income than upper-income people.  

The cross elasticity between imports and domestically-produced vehicles could be higher than for the aggregate.  So, the tariff should result in a significant switch in sales to domestically-produced vehicles from imported ones.   

Tariff as a Tax:  A tariff is essentially a "consumption" tax applied to a subset of goods.  It is easy to avoid paying the tax directly -- don't buy an affected good.  It may not be easy to avoid if the "tariffed" good is used in the production of other goods or services and the latter passes through the higher priced inputs.   The tariff reduces the purchasing power of consumers to the extent it is not avoided.  

This week's US economic data are expected to show modest economic growth.  Consensus looks for little change in the Mfg ISM from 50.3.  It also looks for a slowdown in March Nonfarm Payrolls to +128k from +151k in February and an uptick in the Unemployment Rate to 4.2% from 4.1% -- still an historically low level.  A decline in government payrolls is expected to be partly responsible for the soft data.  Near-consensus prints may not calm the markets' fears by much, as the data might be viewed as being too soon to see the recessionary effects of the tariffs.  Furthermore, the risk of recession is higher when the economy's pace already is slow.

 

 

 

The Fed's Perspective On The Economy and Tariffs

The stock market may stay in a range amidst uncertainty regarding the April 2 announcement of Trump's reciprocal tariffs.  Fears that the tariffs will damage an already slowing economy as well as boost inflation may dominate any news to the contrary at this point.  However, Trump's past actions and recent words suggest there could be less than meets the eye in his threat of reciprocal tariffs, which could limit any stock market pullback ahead of the announcement.

The revised Fed's Central Tendency Forecasts reflect the market's fears, as this year's Real GDP Growth was lowered and inflation raised a bit.  These slight shifts were more an acknowledgement of the expected directions of the tariffs' impacts rather than precise estimates, according to Fed Chair Powell at his post-FOMC news conference.

The Fed is keeping an open mind about how the tariff situation develops.  Powell suggested the Fed would be able to see whether the recent uptick in goods prices reflects tariffs, presumably by seeing whether they are sustained or reversed in coming months.  Importantly, he said that the Fed expects the boost in prices from tariffs will be short-lived.  This suggests the Fed will be slow to react to high CPI/PCE Deflator prints.  It will take several months to see whether the tariffs have a persistent effect on prices. 

Perhaps the most important point made by Powell is that the Fed is focused on economic data, not sentiment surveys, in evaluating the appropriate monetary policy stance.  And, so far, the Fed does not see any impact of weak sentiments on the overall economy.  Indeed, the FOMC Statement said, "Recent indicators suggest that economic activity has continued to expand at a solid pace."  As a result of the Fed's perspective, weak sentiment surveys could become less important for the markets as long as the economic data remain robust.

Last week's US economic data were mixed with regard to the Fed's assessment of the economy.  Consumption looks soft in Q125, but possibly set up to do better in Q225.  Manufacturing Output is back on an uptrend.  The Unemployment Claims data show layoffs remain low but suggest companies remain cautious in hiring.

Consumption still looks to have slowed in Q125 despite the modest rebound in February Retail Sales.  Retail Sales Excluding Motor Vehicles and Gasoline in February were  0.3% (annualized) below the Q424 average.  However, the weakness in the first two months of the year could be just the typical pause after a strong month (December).  Also, bad weather may have played a role, in which case a bounce-back in Q225 is possible.  Supporting this possibility, the February level of Sales is 0.9% (annualized) above the January-February average.  (Retail Sales is just a part of Consumer Spending, but their weakness in January-February fits with large retailers' complaints.)

The 0.9% jump in February Manufacturing Output was led by a rebound in Motor Vehicle Production (to above the Q424 average) and continued strength in High Tech Output (computers, communication equipment and semiconductors).  Away from these two sectors, Manufacturing Output rose moderately for the third month in row -- after falling over most of H224.  This week, consensus estimate of a +0.4% m/m increase in February Durable Goods Orders Ex Transportation supports the view of an uptrend in manufacturing.

The Claims data tell a mixed story.  Initial remained low in the latest week, reaffirming relatively few layoffs are occurring.  However, Continuing rose to the high end of its recent range, suggesting hiring has slowed.  Their bounce could be volatility, though, so it's too soon to draw a firm conclusion about their implications.

The perception of the consumer may improve this week if consensus estimate of +0.6% m/m for February Consumer Spending is right.  Taking account of the consensus estimate of +0.3% m/m for the PCE Deflator (both Total and Core), Real Consumption in February would be 0.8% (annualized) above the Q424 average and 0.4% above the January-February average.  This still shows slower consumer spending than the 2024 pace, but spending remains in an uptrend.  And, the risk is for a lower-than-consensus print for the PCE Deflator, given that the February CPI was 0.2% (both Total and Core).  In this case, Real Consumption would be stronger if the 0.6% increase in Nominal Consumption prints. 

 

 

 

 

 

 

 

Eyes on The Consumer

The stock market could get some relief from February Retail Sales if consensus estimates are right.   Despite recent negative comments from retailers, consensus looks for +0.7% m/m Total and +0.5% Ex Auto.  This could be a weather-related rebound after declines in January (Total down 0.9% and Ex Auto down 0.4%).  Whether the health of the consumer is affirmed by this report could depend on how the January-February average stacks up against Q424 or how February's level compares to the January-February average.  The greater the improvement in either, the healthier the consumer.  If the retailers are right and retail sales fall again, the recession risk will get more play and hurt stocks.

Retailers blame fears of inflation and recession for the sudden consumer pullback they see.  These reasons appear to be confirmed by the University of Michigan Consumer Sentiment Survey.  The irony is that the latest data don't support these fears.  The February CPI and PPI showed that inflation remains near trend, if not slowing a bit.  And, Unemployment Claims indicate a still solid labor market.  Both Initial and Continuing Claims in February are within the low ranges seen since September-October. 

This would not be the first time the consumer pulled back sharply on questionable fears.  The consumer "went on strike" in 1980, reacting to misunderstood Credit Controls by the Carter Administration.  Many consumers apparently believed the Controls banned the use of credit cards, and they stopped spending as a  result.  The economy went into a steep dive that lasted two quarters.  Then, an ending of the Controls and lower interest rates led to a sharp rebound in spending and economic activity in the second half of the year.  

To be sure, there is a possibility that a sudden weakening in consumption has resulted from the stoppage of immigration.  Spending may have slowed as did population and employment growth.  This possibility raises the risk that the trends in consumption and the economy have ratcheted down. 

Trump's tariff actions and threats may continue to be a problem for the stock market.  They have been a mixture of temporary "transactional" moves to achieve an unrelated goal and more permanent revenue-producing tariffs.  The markets are never sure in which category a tariff announcement should be viewed, helping to explain the stock market's wild reactions.  The tariff problem should end for the market when the various countries decide to sit down together to settle the situation, just like what happened between the US and China in 2019-20.

There is a simplistic way of looking at tariffs that may shed light on Trump's actions.  Think of the economy as consisting of producers and consumers.  This is simplistic because everyone is a consumer.  Trump is aiming to help producers by protecting them from foreign competition.  But, he is downgrading consumers.  This split was articulated by Treasury Secretary Bessent, who said "access to cheap goods is not the essence of the American Dream."  Instead, he said "the American Dream is rooted in the concept that any citizen can achieve prosperity, upward mobility, and economic security."

With all this going on, it should not be surprising if this week's FOMC Meeting is a non-event, ratifying Fed Chair Powell's recent comments that monetary policy is on hold.  He will likely restate the policy restraint necessitated by the uncertainty surrounding Trump's policies.  The Central Tendency Forecasts will not likely change much from December, including the possibility of 1-2 rate cuts this year.

 

 

 

Focus On The Economy

The stock market may continue to be weighed down by uncertainty over Trump's tariff policies and their implications for growth and inflation.  Evidence so far points to slow economic growth in Q125  and a continuing downtrend in inflation -- not as bad as feared.  This week's releases of the February PPI and CPI could confirm the downtrend in inflation.

Consensus looks for +0.3% m/m  for both the February Total and Core CPI.  This would be down from 0.4% Total and 0.5% Core in January (start-of-year price hikes).  A 0.2% print for both cannot  be ruled out, even though last year February Core repeated January's high 0.4% print.  Airfares will not likely jump as they did in February 2024.  

Consensus also looks for 0.3% m/m for both February Total and Core PPI.  The Total would be down slightly from 0.4% in January.  Core would match its pace in January's as well as in February 2024, so the y/y should be steady at 2.2%.

The February Employment Report pointed to slow economic growth and low wage inflation.  While it did not completely shut the door on recession, it did not confirm one either.  There were signs of cautious behavior by companies rather than their "throwing in the towel" to brace for recession.

Some of February's +151k m/m Payroll gain was likely a weather-related rebound from January.  The 2-month average, which eliminates the weather effects, is +138k, consistent with a steady Unemployment Rate.  Indeed, the rebound in the Unemployment Rate to 4.1% from 4.0% in January puts it back to the Q424 average.  Although both Civilian Employment and Labor Force fell, the declines could be due to the small sample bias of the Household Survey. This bias is canceled out in the calculation of the Unemployment Rate, making the latter more significant than its components.  A steady q/q Unemployment Rate is not indicative of recession.

The one part of the Report that keeps the "recession" door open is the soft Total Hours Worked (THW).   Although they edged up m/m, they remained below the Q424 average.  The January-February average is 0.5% (annualized) below the Q424 average.  However, Q125 Real GDP Growth still could be positive once productivity is taken into account.  A low Nonfarm Workweek is responsible for the q/q decline in THW.  It suggests companies are responding cautiously to tariff uncertainty by working fewer hours rather than taking the more drastic action of cutting headcount.

There are signs in the Report that DOGE is reducing headcount in the Federal Government.  Jobs there fell 10k m/m (7k in Postal, 3k elsewhere).  The typical m/m change is +3k.

Some of the January-February Payroll slowdown could have resulted from labor shortages stemming from the drop in immigration.  If so, an increase in Job Openings is conceivable.  This week's release of JOLTS data will show Job Openings data for January.  However, it may be depressed by the bad weather and could be too early to see an impact from the drop in immigration.  

Perhaps reflecting a slower economy, wage inflation is back to looking tame.  The 0.3% m/m increase in Average Hourly Earnings in February, after a downward-revised 0.4% in January (was 0.5%), is below the recent 0.4% trend.  The February slowdown was widespread across sectors.

Besides the February Employment Report, there were other important data released last week:

1.  The decline in Initial Claims back to their recent low trend suggests the prior week's jump was related to faulty seasonal adjustment for the holiday.  A drop in Continuing Claims in next week's report would help to confirm this reason.  At this point, the labor market still looks solid.

 2.  Labor Compensation -- the broadest measure of labor costs -- were revised down sharply in both Q424 and Q324.  It now shows that Compensation/Hour rose only 3.8% q/q saar (was 4.2%) in Q424 and 1.3% (was 2.9%) in Q324.  The y/y is now reported as 4.0% in Q424 (same as the y/y for AHE in February) and 2.0% for Unit Labor Costs (which takes account of productivity growth).  The latter is in line with the Fed's 2% inflation target. 

A Positive Development Re Tariffs?

The stock market could be helped by tariff developments this week.  The latest news stories suggest Trump's threat of tariffs on Canada and Mexico is meant to persuade them to impose tariffs on China.  Mexico is said to have agreed to do so and could announce it on Tuesday.  It remains to be seen whether Canada will do so, as well.  Presumably, the US will not impose tariffs on them if they, in fact, follow through.  This would be a positive for stocks and fit with the historical tendency for them to move up in March, more so in April.

At the same time, the markets should continue to be concerned that the tariffs will lead to slower economic growth, if not recession, and higher inflation.  These effects may not happen immediately.  As a result, evidence to the contrary could be dismissed for being too soon to show the effects.  And, evidence that seems to support these concerns could spark a sell-off. 

From this perspective, this week's key US economic data should have little impact on the stock market if consensus estimates print.  The February Employment Report and Mfg ISM are not expected to validate the market's  fears, and thus may be discounted.  

Consensus sees a modest +133k m/m increase in Nonfarm Payrolls, not much different from the +143k in January, a  steady 4.0% Unemployment Rate, and an uptick in the Nonfarm Workweek (weather-related rebound).  Such prints would not indicate recession.  The market may focus on whether DOGE has in fact reduced Federal government jobs.  The jump in Initial Claims to an above-trend level in the latest week may have reflected these layoffs.  However, the Claims data were for a week after the Payroll survey week. Also, the week contained a holiday, which raises the possibility that seasonal adjustment may have exaggerated the increase.  The higher level of Claims needs to be confirmed in this week's release to be meaningful.

Consensus also expects a slowdown in Average Hourly Earnings (AHE) to 0.3% from 0.5% in January.  This would be good news for the inflation outlook as it would be below the prior 0.4% trend.  The market may discount a low print as not yet reflecting attempts by labor to counter the inflationary effects of the tariffs.

Consensus also looks for the February Mfg ISM to stay high, edging down to 50.8 from 50.9 in January.  The Non-Mfg ISM is expected to rise to 53.0 from 52.8.  Although still relatively low, an uptick could be important after the Market PMIs for both the US and Europe showed a sharp weakening in Service Sectors in February.  In Q424, the Mfg ISM averaged 48.1 and the Non-Mfg ISM averaged  54.1.

The Atlanta Fed model dropped its latest estimate of Q125 Real GDP to -1.5%, feeding fears of recession.  This is an early forecast based on little data, however.  In particular, the decline resulted from a large decrease in Net Exports due to a jump in imports of industrial supplies.  This jump may have been in anticipation of tariffs.  If so, much of them most likely was held in inventories.  This did not show up in January inventory data, however, but could appear in data for February or March.  There is often a timing difference between the Trade Deficit and Inventory surveys.  So, the Atlanta Fed model's estimate should probably be viewed with caution.

 

 

 

 

 

 

 

 

Sell-Off Overdone?

The stock market will face two more data points this week that will offer an opportunity to see whether it overreacted to second-tier US economic data at the end of last week.  Consensus-like prints for the Conference Board's Consumer Confidence Index and the PCE Deflator could offer relief.   But any bounce-back may be impeded by concern over the March 1 deadline for Trump's decision regarding 25% tariffs on Canada and Mexico and the April 1 deadline regarding tariffs on several major goods.   Overall, Trump's pronouncements and policies are creating a troublesome backdrop for the market.

The market will likely pay close attention to the February Conference Board's Consumer Confidence Index to see if it confirms the drop in the University of Michigan Consumer Sentiment Index.  Consensus looks for a modest decline to 102.1 from 104.1 in January, after it dropped 5 points in January.  A consensus-like print still may provide relief, as it would remain in the range seen in 2024.  The Conference Board measure is viewed as more closely related to the labor market than is the Michigan Sentiment Index.  Although government layoffs could hurt the Conference Board measure either directly by laid off workers who are surveyed or by impacting others' views of the labor market, the Unemployment Claims data don't indicate a significant deterioration in labor market conditions.

From the Fed's perspective, the most important data last week was likely the University of Michigan's 5-Year Inflation Expectations.  It jumped to 3.5%, it highest level since 1995.  It throws into doubt Powell's long-maintained contention that inflation expectations are contained.  Higher food prices and fear of tariffs were likely behind the jump.  This week, the release of the January PCE Deflator could assuage market concerns, as consensus looks for +0.3% m/m  Core.  If correct, the y/y for Core should fall to 2.6-2.7% from 2.8% in December.  The Conference Board Consumer Confidence Survey also includes 12-month inflation expectations.  It rose to 5.3% in January from 5.1% in December.

There could be some relief if Trump delays tariffs on Canada and Mexico again.  The FX market appears to believe this will be the case, as the Canadian dollar and Mexican Peso are off their recent lows.  Trump set April 1 as a possible time to announce tariffs on some goods, such as motor vehicles and pharmaceuticals.  A tariff on motor vehicles may not be necessarily bad for US auto makers.  It would allow them to raise prices, probably more than making up for the  new tariff on steel and aluminum and the tariff applied to the vehicles they make in Mexico and Canada. 

That said, Trump's topsy-turvy views of the world have increased uncertainty regarding the future.  This uncertainty could hurt current economic activity.  Besides forcing companies to rethink their supply channels (and the accompanying increased costs) to take account of possible tariffs, the potential drag on economic activity from them or a trade war could weigh on investment decisions.  The drop in the February Phil Fed Mfg Survey's measure of planned capital expenditures to its lowest level since November hints as such.  It may be too soon, however, to see a similar effect in this week's release of January Durable Goods Orders.  Consensus looks for a decent 0.4% m/m increase in Orders Ex Transportation, a larger increase than the 0.3% in December.

 

 

Macro Problems Dissipate For Now

The stock market may continue to climb this week in the absence of significant US economic data and an apparent pause in implementing tariffs.  The Fed is firmly in the background for several reasons.  Instead, the implications of the evolving macroeconomic path for monetary policy will be best seen in the ups and downs of long-term Treasury yields.  At this point, economic growth and inflation look satisfactory, once special factors are taken into account.

Fed monetary policy is on hold.  Powell and other Fed officials have made this clear, saying both policy and the economy are in a good place.  Besides these fundamental reasons for steady policy, Trump's call for lower rates stymies rate decisions in both directions.  Unless there is convincing evidence that a policy change is needed, cutting rates would raise concern that the Fed is buckling under political pressure.  Raising rates would bring on even more political pressure.  The Fed is likely to be very careful in its deliberations over the next rate move. 

Both inflation and real-side economic data for January may have been impacted by special factors, which allowed the market to discount their significance.  Although the January CPI rose more than expected, large increases in just a handful of components were responsible.  They were likely one-off start-of-year price hikes.  Bad weather across the country probably caused January Retail Sales to fall.  The part of Retail Sales that feeds into the calculation of Consumer Spending in GDP was flat relative to the Q424 average.  Sales should rebound over February and March, however, as the weather improves.  This week's January Housing Starts could be depressed temporarily by the weather, as well.  

The sustained low levels of Initial and Continuing Claims into February attest to the underlying solid performance of the economy despite the bad weather.  The strength of commodity prices also suggests US and global economic growth are doing fine.

There remains a question regarding the underlying pace of the economy and inflation once these temporary factors iron out.  The Trump Administration's cutting or disrupting government spending, both at the federal and state levels,  could exert some drag on the economy.  In addition, the plunge in illegal immigration could restrain both government spending and consumption.   As for inflation, the pass-through of the tariffs on China and steel and aluminum to consumer prices remains to be seen.  And, wage rates remain an issue, despite Powell's assertion that it is not a source of inflationary pressures.  The continuing sharp increase in food prices could spark demands for higher wages.

The tariff issue is now "in committee" as Trump directed officials to determine how to implement "reciprocal tariffs."  News reports suggest they will be difficult to implement, as many imports are made across a number of countries.  Perhaps in the end, the threat of reciprocal tariffs could be just a bargaining tool to force other countries to cut their tariffs on US exports, as has happened to some extent already with India.  In this case, reciprocal tariffs would not be a problem for the stock market.  The market, however, may turn cautious as the March 1 decision regarding Canadian/Mexican tariffs approaches.

 

 

 

 

 

Reciprocal Trade, Powell, CPI and Immigration

The stock market will be on edge this week ahead of Trump's announcement of so-called "reciprocal trade or tariffs."  Although it is not exactly clear what that means, it presumably involves connecting tariffs to tariffs or other trade barriers imposed on US exports -- potentially bad for stocks but not necessarily.  Trump says he'll hold a meeting regarding this issue Monday or Tuesday.  In contrast, the market may find relief in Fed Chair Powell's Semi-Annual Monetary Policy Testimony and key US economic data.  

Reciprocal tariffs apparently means imposing tariffs on countries to the extent they have imposed tariffs or trade restrictions on the US.  The questions for the market are /1/whether such a move would trigger a trade war, with other countries responding by raising their tariffs further?  or,  /2/ would it be used as a lever to persuade countries to remove their tariffs or restrictions on US exports?  An affirmative answer to the first question is a negative for stocks, while an affirmative for the second would be a relief and an eventual positive.  There is also a middle ground.  Trump may announce additional penalties for countries that respond by raising tariffs further, which would mitigate the risk of a trade war.  But, he also could view these new US tariffs as government-revenue-producing instruments.  The latter would suggest the tariffs will not end quickly, unlike the Mexican and Canadian 25% tariffs.  Stocks may find relief in such a middle ground, as the first possibility would lower the risk of a trade war while the second would take time to implement. 

Stocks should not find Powell's testimony problematic.  He will likely reiterate the message from the January FOMC Meeting -- growth is solid, inflation is moderating but still too high, and monetary policy is now on hold as there is a lot of uncertainty regarding fiscal policy ahead.  Powell may say the next policy move will depend on the data and not on demands by President Trump.  

Consensus looks for 0.3% m/m increases in Total and Core CPI for January.  This would not be a bad print, given the risk of start-of-year price hikes.  The Core CPI rose 0.4% in January 2024.  A 0.2% print can't be ruled out,  particularly if Owners' Equivalent Rent slows from 0.3% in December.  A consensus or sub-consensus print could allay inflation fears seen in the University of Michigan Consumer Sentiment Survey and long-term Treasury yields.

Despite Fed Chair Powell's protestation that the labor market is not a source of inflationary pressures, labor costs remain a risk to the Fed's 2% inflation target.  In Q424, Compensation/Hour -- the broadest measure of labor costs -- rose a near-trend 4.2% (q/q, saar).  It equaled the Q4/Q4 pace for 2024 and remained below the 4.8% 2023 pace.  So far so good for Powell's assertion.  However, the Q424 pace is not good for the inflation outlook if the slowdown in Productivity to 1.2% in Q424 is the new trend (was 2+%).  Then, Unit Labor Costs (ULC) would be rising around 3.0%, which is too high for the Fed to achieve its inflation target.  Whether this is a new ULC trend is too soon to say, particularly given the volatility in the measures of Compensation/Hour and Productivity.  Nonetheless, it shows that the markets still have to watch wage measures carefully.

That said, the outsized 0.5% m/m jump in January Average Hourly Earnings (AHE)  has to be viewed cautiously for three reasons.  /1/ It could have been caused by compositional shifts stemming from the month's bad weather.  /2/ There could have been one-off start-of-year hikes (AHE jumped 0.5% in January 2024, as well, followed by 0.2% in February).  /3/ Four of the thirteen major sectors had large increases that just unwound declines in December.    The two-month average of AHE is 0.4%, in line with trend.

Although consumers are concerned about the inflationary impact of tariffs, prices of imported consumer goods have not been a problem.  Excluding motor vehicles, these prices were flat over 2024, while imported motor vehicle prices rose only 2.4%.  The latter turned down a bit over the last two months of the year to boot.  The strong dollar was one reason for this favorable picture -- and the dollar will likely strengthen even more if additional tariffs are implemented.  Ironically, a stronger dollar would be an offset to "reciprocal trade" actions, making imports cheaper and exports more expensive (in foreign currency). 

The economic growth implications of the January Employment Report were mixed.  On the weak side were the slowdown in Payrolls and decline in the Nonfarm Workweek.  On the strong side was the dip in the Unemployment Rate.

The Payroll slowdown and decline in the Nonfarm Workweek could have been impacted by the month's bad weather, although BLS says it did not see any discernible weather impact in its survey.  Their soft prints resulted in Total Hours Worked in January being 0.7% (annualized) below the Q424 average.  This is a weak start to Q125, but could reverse as the bad weather effects unwind over February and March.  Such recovery would set the stage for a sizable q/q bounce in THW in Q225.  However, the slowdown in Payrolls instead could become the "new" trend, held back by labor shortages as discussed below.

The dip in the Unemployment Rate to 4.0% puts it below the 4.1% Q424 average.  This decline suggests economic growth remains above its longer-term trend.  Indeed, the Rate would have fallen by 0.2% pt were it not for upward revisions to the annual Population Controls.  

However, there is a cautionary story to tell about US population.  The 2.8 Mn in net immigration accounted for 85% of US population increase (3.3 Mn) in 2024, according to the Census Bureau.  This inflow of immigrants presumably accounted for most of the employment growth last year.  A dramatic reduction of net immigration as a result of Trump's border policy could be problematic for the Fed.  The lack of workers could be a significant constraint on economic growth.  At the same time, labor shortages could boost wage and thus price inflation.   The Fed might have to tighten to bring demand into sync with supply.

 

 

 

Tariffs Are Bad For Stocks

The stock market will likely be hurt by Trump's tariffs on Canada, Mexico and China, since tariffs have the potential to precipitate weaker economic activity and higher inflation.  However,  it may take time to see the effects, so the market may stabilize after a knee-jerk reaction as it waits to see the fall-out.  This week's key US economic data could help the market stabilize if they print near consensus.

Regarding the fall-out, negatives would be further retaliatory actions by these countries and/or anecdotal or reported price hikes.  Although shifting the locations of production may avoid tariffs, almost by definition the shifts would be to more costly places and not be market positive.  Positives would be if the three countries agree to address the fentanyl problem and thereby end the tariffs.  Also, some domestic producers could boost their profits by raising prices to match the tariffs.  

Recent history shows that tariffs and trade wars are not good for the stock market.  In Trump's first term, the stock market rally stalled for a year when he imposed tariffs and other trade barriers on China beginning January 2018.  Just like then, Trump may not be quick to undo the tariffs -- the U.S and China signed an agreement on trade in January 2020.  He may become enamored with the revenue-producing benefit for the government, helping to pay for extending his earlier tax cuts.  Doing so essentially would be substituting a "consumption tax" for an "income tax."  This substitution would have several implications.  On the plus side, a higher consumption tax increases the incentive to save.  Also, maintaining low marginal income tax rates sustains incentives to invest and work.  However, the substitution makes the government revenue machinery less "progressive," that is more a burden to lower-income than upper-income people.

The tariffs will augment Trump's anti-immigration policies in working to boost the cost of goods.   Imports are a way US consumers benefit from low-priced labor abroad without incurring the cost of bringing the workers to the US.  Tariffs serve to close this channel.  From the US labor unions' perspective, lower-priced foreign labor or increased labor supply from immigration puts downward pressure on wages.  The FX exchange rate in a perfectly competitive world should offset lower wages abroad, but the FX market is not perfectly competitive and is impacted by other factors, as well.

Regarding these other factors, there is also a novel way to look at the trade deficit in the context of whether other countries are not paying their fair share of global defense.  The military strength of the US is one factor behind the strong dollar.  Safe-haven inflows of foreign capital lifts the dollar, which in turn widens the trade deficit.  A wide trade deficit means that the US is consuming more than it produces.  This "excess" consumption can be viewed as foreign payment for US defense.  So, cutting the trade deficit would reduce this "payment." 

Away from the tariffs, the bottom line from Fed Chair Powell's post-FOMC news conference last week is that monetary policy will be steady for the foreseeable future.  More than one or two months of adverse or friendly data will be required to convince officials to change policy.  He said current policy and the economy are "well positioned."  And, Fed officials are not "in a hurry" to change policy.  

This week's key US economic data are not expected to move the Fed.  Consensus looks for a moderate January Employment Report and little change in the Mfg ISM.  Nonfarm Payrolls are seen increasing  170k m/m, equaling the Q424 average m/m pace.  It would be below the 186k average m/m pace in all of 2024.  Some softening in January job growth could stem from the extremely cold weather in parts of the country during the month.  It could have prevented some construction or other work, holding down jobs or workweek or both.  Such weakness should be viewed as temporary.

The Unemployment Rate is expected to be steady at 4.1%.  However, there is downside risk, as the consensus Payroll estimate exceeds the 125k pace that is roughly consistent with a steady Unemployment Rate.  Consensus  also looks for Average Hourly Earnings to rise 0.3% m/m, which would be an acceptable pace for the Fed.  Powell, himself, does not believe wage inflation is a problem.  He asserted that the labor market is "not a source of inflationary pressures."

Consensus sees an uptick in the January Mfg ISM to 49.5 from 49.3 in December.  (This Report will contain historical revisions stemming from new seasonal factors.)  This would keep the Index above the 48.1 Q424 average and be the highest level since March 2024.  Nevertheless, the level is still historically low and signals a sluggish manufacturing sector.  It is probably too soon to see any impact from the tariffs in this survey.  It took a long time for the Mfg ISM to show the effects of the US/China trade war in 2018, as it stayed at a high level until November.

Tariffs Loom, But OK FOMC Meeting and US Economic Data

The stock market may trade cautiously ahead of the February 1 deadline regarding 25% tariffs on Mexico and Canada.  Trump could go through with them (a market negative) or hold back and announce negotiations (a market positive).   The market should take this week's FOMC Meeting in stride.  Although the Fed will not cut rates, it will likely keep open the door for cuts later this year if needed.  Corporate earnings as well as this week's key US economic data will likely be market positives. 

Trump's threat to impose 25% tariffs on imports from Columbia is minor compared to such a tariff on Mexico and Canada.  US imports from Columbia were about $18 Bn last year, versus about $900 Bn from Mexico and Canada combined.

There are two reasons to expect the Fed to keep monetary policy steady at this meeting.  /1/ The macroeconomic background does not call for lower rates.   GDP Growth is strong and the labor market solid.  Underlying inflation is on the desired downward path, but the pace is still too high.  /2/ Trump's insistence that rates should be cut almost guarantees the Fed will not do so.  Fed officials need to show their independence, which they view as paramount.  Moreover, if they cut rates, inflationary implications of the implicit loss of independence would boost longer-term yields and weaken the dollar. 

In his post-Meeting news conference, Fed Chair Powell, nevertheless, will likely keep open the door for rate cuts later this year, since this possibility is part of the projections made at the December FOMC Meeting.  However, he may indicate that policy easing will happen only if warranted by economic conditions.  The trend in economic growth would have to weaken and inflation continue to slow.  (Note that the extremely cold weather in parts of the country could hurt economic activity temporarily.)  This policy stance should be positive for the stock market.  Continuing solid economic growth is good for profits, so  a steady Fed is not a problem.  Moreover, having a ready-to-ease-if-needed Fed in the background puts a floor on downside risks in the economic outlook.

Powell is likely to downplay any suggestion of policy tightening that may arise among the questions raised by reporters.  He could say this possibility was not discussed at the meeting and is not part of the officials' projections made in December.  Although economic growth appears to be continuing at a faster pace than expected by the Fed, officials will likely tolerate it for two reasons.  /1/ Strong productivity growth has been an important factor behind recent GDP growth.  To that extent, the growth should not be inflationary.  /2/ Labor cost inflation remains in check, particularly according to the broadest measure, Compensation/Hour.

Powell will not likely comment on Trump's policy proposals, such as clamping down on immigration and extending tax cuts, citing uncertainty surrounding them -- uncertainty regarding whether or to what extent they will happen and also what their effects might be.  

This week's key US economic data are expected to be market-friendly both for stocks and Treasuries.  The first release of Q424 Real GDP Growth is seen by consensus at a robust 2.7% (q/q, saar), close to the Atlanta Fed Model's forecast of 3.0%.  Consensus also sees a benign 0.2% m/m increase for the December Core PCE Deflator.  Although the modest December CPI suggests downside risk to the PCE Deflator, the large increase in PPI Airfares will feed into the PCE Deflator and stands as an offset.  The y/y for Core should be steady at 2.8%, but an uptick to 2.9% can't be ruled out.  Consensus expects the Q424 Employment Cost Index (ECI) to slow to 1.0% (q/q) from 1.1% in Q324.  Average Hourly Earnings (AHE)  supports the idea of a slowdown in the ECI, as speedups/slowdowns in the AHE were matched by the ECI a quarter ahead in 5 of the past 6 quarters (see table below).

                             (q/q percent change)

                          AHE                        ECI 

Q423                1.0                            na 

Q323        1.0     1.1

Q223        1.2     1.0   

Q123                0.8                            1.2                  

Q422                1.2                            1.1

Q322                1.1                            1.2

Q22                  1.1                            1.3   

Q122                1.3                            1.4