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.
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