The New Warsh Fed

The stock market should continue to be subject to developments in the Iran war this week.  It also may trade cautiously into the release of the May PCE Deflator on Thursday, now that the new Fed Chair Warsh emphasized the Fed's intent to bring down inflation.  A below-consensus, trend-like print can't be ruled out, which, however, still might not resolve the question whether the Fed will hike rates at the next FOMC Meeting on July 28-29.  Warsh said that the current trend in inflation is too high.

Warsh was adamant that the Fed will bring down inflation, repeating this promise many times at his news conference.  In some sense, his reiterations sounded as if he "protested too much," perhaps because he had to free himself from his earlier message that rates should be lowered.  Jawboning like this could allow the Fed to hold back tightening, ironically.  Indeed,  his emphatic statements have already led to anti-inflation market developments -- a stronger dollar and lower commodity prices.  However, asked why the Fed did not hike at the meeting he suggested the question could be addressed at the July FOMC Meeting.  So, the risk of a rate hike then remains. 

This week's May PCE Deflator will be the last Deflator release before the July FOMC Meeting.  It's possible some Fed officials may get an early look at the June PCE Deflator in time for the Meeting, however.  The June CPI will have been released, as well.

Consensus looks for +0.3% m/m in the Core PCE Deflator for May  The y/y would rise to 3.9% from 3.8%, assuming no revisions to prior months.  The Core needs to average 0.2% m/m from May through December to keep the y/y at 3.8% by year end.  Such a below-consensus print for May can't be ruled out, inasmuch as the May Core CPI already printed 0.2%.  However, a 0.2% print might have to be from a low un-rounded increase (for example, 0.15% -- annualized, 1.8%) to be Fed-friendly.  A 0.1% print would be a market positive.  

It is not clear what measure of the PCE Deflator will be emphasized by the Fed.  Presumably, the Inflation Task Force, one of the five he is establishing, will provide guidance later this year.  Meanwhile, the market may focus on the Trimmed version of the PCE Deflator, which in the past Warsh has said is preferable.  The latest figures show this measure to be close to the Fed's 2% target:

One-month PCE inflation, annual rate

	25-Nov	25-Dec	26-Jan	26-Feb	26-Mar	26-Apr
PCE	2.7	4.0	4.0	4.9	8.3	4.9
PCE ex F&E	2.2	4.0	5.2	4.9	3.6	2.9
Trimmed mean	1.7	2.2	2.6	2.0	2.9	2.5

Six-month PCE inflation, annual rate

	25-Nov	25-Dec	26-Jan	26-Feb	26-Mar	26-Apr
PCE	2.8	2.9	3.2	3.5	4.4	4.8
PCE ex F&E	2.7	2.8	3.2	3.5	3.8	3.8
Trimmed mean	2.3	2.1	2.2	2.0	2.2	2.3

12-month PCE inflation

	25-Nov	25-Dec	26-Jan	26-Feb	26-Mar	26-Apr
PCE	2.8	2.9	2.9	2.9	3.5	3.8
PCE ex F&E	2.8	3.0	3.1	3.0	3.2	3.3
Trimmed mean	2.5	2.4	2.4	2.3	2.4	2.3

Although Warsh said the labor market is on the right track, with job growth matching population growth, the latest Unemployment Claims data hint at some softening.  So far in June, both Initial and Continuing are above their May averages (see table).  They suggest that layoffs have risen and hiring restrained.  If the higher levels are sustained, they would suggest a slowdown in June Payrolls.  This outcome may be a restraining consideration at the next FOMC Meeting.

                                          Latest in June        May Average               

 Initial Claims                      226k                    212k                              

Continuing Claims            1.810 Mn              1.778 Mn             

 

 

 

 

Will the FOMC Tilt The Risks?

The stock market will continue to be impacted by developments in the Iran war this week, with the announced agreement to end the war a positive.  In addition, the market will focus on this week's FOMC Meeting -- the first when the new Chair, Kevin Warsh, will preside.  A key question is whether he convinces the Committee not to include language in the Statement suggesting the risks in the outlook have tilted toward higher inflation and thus to tightening.  Powell had said there was some discussion about doing so at the prior FOMC Meeting.  An unchanged tilt in the outlook risks in the FOMC Statement would likely be a positive for the stock market.

The latest evidence supports a case not to tilt the risks:

The subdued 0.2% m/m Core CPI in May resulted from fairly widespread soft prints.  More than half of the major components posted price changes of 0.2% or less.  So, the modest increase in Core was an accurate depiction of the overall inflation situation.  (The high May PPI, in contrast, was boosted by just a handful of components.)  To be sure, the Core CPI's y/y rose to 2.9% from 2.8% in April.  However, the uptick appears to be caused by a small boost from y/y shifts in seasonality.  The y/y of the seasonally adjusted Core was steady at 2.8%.   

Although higher energy prices continued to boost the Total CPI in May, the decline in oil prices in June points to a more subdued Total in coming months.  Food Prices may be stabilizing, as well.  They rose 0.2% m/m in May, with Food At Home rising only 0.1%.   

An impediment to achieving the Fed's 2% target for inflation is the stickiness in housing rent, particularly the heavily weighted Owner's Equivalent Rent (OER).  It's been running well above 2% (3.3% y/y in May).  This means that other components of the CPI would need to rise by 1.0% or less to achieve the 2% target, unless OER slows sharply.  The economy may need to weaken significantly for such a broad softening in inflation to happen.

The Fed knows this consequence, which is why Powell always pointed to the Core PCE Deflator Excluding Shelter as a better way to measure inflation.  In May, the Core CPI Excluding Shelter rose 0.1%.  Its y/y was 2.4%.  Warsh's favorite inflation measure -- the Trimmed PCE Deflator -- presumably includes OER, but it rose 2.3% on both a 6-month and 12-month basis in April. 

Evidence on labor costs offers a reason to base policy on the low pace of these measures. Labor Costs rose by just over 3.0% (y/y) according to all the major measures.  This pace should be consistent with about 2.0% price inflation, taking account of productivity gains.  

It is questionable whether OER -- which accounts for a quarter of the Total CPI and about a third of Core -- should be included in a policy target.  This is because nobody pays it!  It's an imputed rent, measuring what homeowners would pay if they paid rent.  Moreover, if they did pay rent, they would be paying it to themselves.  It's used in the CPI because it was meant to be an improvement over the prior method of measuring the price of "housing services" to homeowners -- basing it on the mortgage rate and home price.  This prior method had its own problems.  

Regarding the labor market, the Unemployment Claims are beginning to show some softening.  Both Initial and Continuing Claims have inched up in the past few weeks. 

The Meeting will have updates to the Fed's Central Tendency Forecasts.  There could be an upward adjustment to Real GDP Growth and inflation.

                                                Fed Central Tendency Forecasts 

                (Q4/Q4% change except for Unemployment which is the level in Q426) 

                                                      2026              Latest  Actual         

 Real GDP                                  2.2-2.5%              2.5% *         

Unemployment Rate                  4.3-4.5%              4.3%    

PCE Deflator                              2.6-3.1%              3.8%      

Core PCE Deflator                     2.5-2.8%              3.3%

*  H126 average of 1.6% Q126 Real GDP Growth and Atlanta Fed Model Estimate of 3.3% for Q226.

 

 

 

A Supportive Macroeconomic Background Continues

The stock market should continue to be subject to two non-economic factors this week: /1/ a pullback in tech stocks, possibly in anticipation of large IPOs and /2/ developments in the Iran war.  The macroeconomic background remains supportive.  This week's release of the May CPI is expected to show a more subdued Core than in April.  And, the May Employment Report points to moderate economic growth with contained wage inflation.  The latter keeps open the door for Fed policy easing at some point.

Consensus looks for the run-up in oil prices to continue to impact the May CPI.  It expects +0.5% m/m for the Total and 0.3% for Core, which would lift the y/y for both.  The risk is for a higher-than-consensus Total and lower-than-consensus Core.  However, with oil prices having declined in the past week or so, the market will likely dismiss a high Total.  The downside risk to Core comes from /1/ the possibility that Primary and Owners' Equivalent Rent fall back to 0.2% m/m rather than 0.3% after the technical catch-up boosted them to 0.5% in April and /2/ no significant speedup in other components.  The lower print should keep the y/y steady at 2.8%.

The May Employment Report implied no need for the Fed to change monetary policy, but it did not close the door for an easing at some point.  The contained Average Hourly Earnings should encourage Fed officials to expect price inflation to eventually move down toward their 2% target once the oil and tariff shocks dissipate.  And, there may have been less than meets the eye with regard to the jobs growth:    

First, although the Report showed a larger-than-expected +172k m/m increase in Nonfarm Payrolls, the increase was narrowly based.  Only 3 sectors accounted for most of the gain: Leisure and Hospitality (+70k), Health Care and Social Assistance (+47k), and State Non-Education Government (+44k) -- +161k in total.  Most other sectors were little changed.  Second, Private Payrolls slowed for the second month in a row, slowing more between April and May than between March and April (-57k versus -25k).  The large gains in March and April conceivably could be just a post-winter rebound, and the more moderate May increase could be on a path to a trend-like pace.      

                                 Private Payrolls (m/m change, 000s)

                                    Jan     Feb      Mar    Apr    May

                                    180     -148       202     177    120                   

The steady 4.3% Unemployment Rate and trend-like 0.3% m/m Average Hourly Earnings (AHE) support the Fed's view that inflationary pressures are not stemming from the labor market.  The moderate pace of wage gains continued to be fairly widespread.   Eight of thirteen sectors showed AHE up by 0.3% or less, not much different from the nine in April when AHE overall rose 0.2%.  The y/y fell to 3.4% from 3.6%, keeping it line with other measures of labor cost inflation.  

Another Report last week underscored the absence of inflation pressures from the labor market.  Compensation/Hour -- the broadest measure of labor costs -- was revised down sharply for both Q425 and Q126 (see table below).  The downward revisions brought the y/y to 3.3% in Q126.  It was 4.3% in Q425 and 4.9% in Q424.

                 Percent Change

        (q/q, saar) 

Compensation/Hr Unit Labor Costs

Revised  Prelim Revised Prelim

Q126     2.1    3.1     1.8   2.3

Q425    3.7    6.3             2.1   4.6

There was some evidence in the May Employment Report supporting the perception that job search by college graduates is difficult.  Both Labor Force Participation and Employment fell for people with a college degree in May.  The lower Participation could reflect discouragement.   The lower Employment shows weak hiring.  Nevertheless, Participation fell by more than Employment, so the Unemployment Rate for them dipped to 2.7% from 2.8% in April.