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.