Non-Economic Factors This Week, But...

The stock market should be dominated by non-economic factors this week -- Iran war developments,  tariff news, and the summit between Presidents Trump and Xi Jinping.  Nevertheless, last week's FOMC results had some market-supportive messages.

Among this week's non-economic factors, the Iran war is probably the most important.  Any change that results in a sharp decline in oil prices could help persuade the Fed and markets that inflation may have peaked.  In particular, the 10-year Treasury yield would likely fall below 5.0%.   

 

There was little that was new in Fed Chair Warsh’s post-FOMC news conference last week.  Regarding monetary policy, he said financial market conditions are not restrictive even after the 25 BP rate hike -- despite the economy being strong and inflation too high.  This keeps open the door for more rate hikes ahead, and the Fed's "dot" chart points to one or two more hikes this year.

 

Warsh cited the above-target 6- and 12-month moving averages of Total and Core PCE Deflator in stating that inflation is too high.  Note, however, that moving averages are backward-looking.  What may be more important is that the Fed's Central Tendency Forecasts call for inflation to move lower to 2.3-2.6% next year and then move even closer to target -- in the 2.0-2.2% range -- beginning in 2028.  Monetary policy, according to the Fed's forecasts, therefore is seen steady to softer during 2027-28.  The stock market should take some comfort in this policy outlook (at least until the data say otherwise), as it is not pointing to so much restriction to bring on a recession.  In addition, the potential for near-term rate hikes should continue to have downward influence on commodity prices and longer-term yields.

 

The markets could take a positive view of Fed policy after they see the August PCE Deflator.  The Fed staff forecasts low prints (due September 30).  The Total PCE Deflator is seen up 3.6% and Core 3.2% y/y.  These estimates imply low 0.2% m/m for Total and +0.1% m/m for Core.  To be sure, the Fed will probably have to see several months of similarly low prints to be persuaded that inflation is coming down significantly.  

 

Meanwhile, the Unemployment Claims data support Warsh's view that the labor market is strong.   Both Initial and Continuing Claims made new lows for the move down in the latest week.  At this point, they point to a speedup in September Private Payrolls.  The Atlanta Fed model's latest forecast is 5.1% (q/q, saar) for Q326 Real GDP Growth.  Real GDP rose 1.8% (annualized) over H126, in line with Fed's estimate of longer-run growth in the US.

 

 

 

 

Will Stocks Like A Rate Hike?

The stock market may react positively to a Fed rate hike at this week's FOMC Meeting, while reacting negatively if the Fed does not hike.   The markets raised their probability of a Fed rate hike after the high August Core CPI was released on Friday.  Are they right?  There continue to be mixed considerations.

Possible Stock Market Reaction 

Stocks may view a rate hike positively for several reasons.  /1/ With the Fed finally moving against inflation, longer-term Treasury yields could fall.  The short-end would be taking on some of the anti-inflation work.  /2/ Tighter policy now may reduce the extent of tightening needed later.  /3/ A tighter Fed could reduce the risk premium in commodity prices.  Lower commodity prices, particularly oil, should be a positive for stocks.  It also would work to lower longer-term yields.

In contrast, steady Fed policy could lift inflation expectations and prompt further increases in commodity prices and longer-term yields, both of which would be negative for stocks.  Also, the risk of Fed tightening after the mid-term elections would increase, possibly by more than if the Fed had moved sooner.   So, this risk would continue to weigh on stocks.  And, the markets could conclude that the Fed was bowing to pressure from the Administration, damaging its reputation of being politically independent.  

Arguments For/Against a Hike 

1. While the 0.3% m/m August Core CPI was on the high side, large increases in a couple of components -- Airfares and Lodging Away From Home -- were mainly responsible.  Higher fuel costs were likely behind the jump in Airfares for the second month in row.  Volatility appears to be behind the bounce in Lodging after the latter dropped in July.  The bulk of the Core components were benign.  The Cleveland Fed's measure of the median CPI and trimmed CPI both rose only 0.2% in August.  So, "fence sitter" FOMC members could decide to keep policy steady despite the high print, blaming it on a "bad" distribution of "noise" and higher oil prices this month.  However, they may vote to tighten in response to the stickiness of inflation.  

2.  A desire not to tighten ahead of the midterm elections could hold back the Fed, as well.   

3.  However, the Fed's credibility could be in question if it doesn't tighten, particularly since Warsh has emphasized the Fed's intent to bring down inflation.  He has said that steady but high inflation is not acceptable.  Although the y/y for the Core CPI slipped to 2.4% from 2.5%, it remains above the Fed's 2% target.  The uptick in the University of Michigan Survey's 5-year inflation expectations to 3.4% from 3.3%, reported Friday, could add to the concern that the Fed is losing credibility, as could the recent sharp increase in longer-term Treasury yields.  

4.  Another consideration, away from the latest inflation data, is that the reasons for the 2024-25 rate cuts no longer apply -- /1/ real rates are not higher because inflation fell and /2/ the labor market is not weakening, unlike what appeared to be the case then.  Arguably, reversing these cuts could be appropriate.  This reason would point to another rate hike later this year even if the Fed hiked this week.

5.  In addition, the US economy is being propelled by several independent forces -- AI build-out, defense spending and re-shoring of production.  Higher rates are needed to make room for them, given the economy is at full employment.  Indeed, as Fed officials like to point out, an AI-caused ratcheting up of productivity growth would require higher market yields.  Otherwise, there could be over-investment.

 

 

 

 

 

 

 

 

All Eyes On The CPI

The stock market may trade cautiously into the release of the August PPI and CPI on Thursday and Friday, respectively, after the strong August Employment Report.   The inflation data may be the deciding factor in persuading FOMC "fence sitters" to vote for or against a rate hike.  One fence sitter, Fed Governor Barr, said last week that he may vote for steady policy if the CPI is benign.  

A consensus-like August CPI would not eliminate the possibility of a September rate hike, but it would not guarantee one either.   Consensus looks for a high 0.4% m/m increase in the August Total CPI, boosted by higher oil-related prices resulting from Iran war developments.  A high Total, however, could be dismissed as temporary.  In contrast, a consensus-like Core CPI would point to "sticky" inflation, which Fed Chair Warsh says is unacceptable.  The Core is expected to print 0.2% m/m, which would equal the January-July average and remain above the Fed's 2.0% target on an annualized basis.   The y/y would slip to 2.4% from 2.5% for Core.   The downtick could be viewed positively by the Fed and stock market. 

A lower-than-consensus print for both Total and Core also cannot be ruled out.  Housing Rent (both Primary and Owners' Equivalent) would have to slow from July's 0.3% pace.  And, Airfares need to be flattish to down as would some other typically volatile components like Used Car Prices and Lodging Away From Home.

Fed Chair Warsh, in his Jackson Hole speech, referenced a wide decomposition of the PCE Deflator among his arguments to hike rates (see last week's blog).  A decomposition of the Core CPI by broad components shows most printing 0.2% or less in each of the past three months (see table below).  However, the share was only just above 50% in May and July, when the Core CPI printed 0.2% overall.  So, even though the decomposition differs from Warsh's PCE Deflator figures, it still shows that a broadening slowdown among CPI components is needed to achieve the Fed's inflation target.  It is not clear whether FOMC fence sitters will need to see a broadening slowdown to keep rates steady and not hike rates.  However, a broadening presumably would raise the possibility they will vote to keep policy steady.

                               Number of Broad Core CPI Components                

                             0.2% or less            0.3%        0.4% or more           Core m/m % change

May                            8 (57%)               2                4                                     0.2

June                          11  (79%)              1                2                                      0.0

July                            8   (57%)              1                5                                      0.2

 * number in parentheses is % of the distribution 0.2% or less. 

The August Employment Report confirmed the Fed view of a solid labor market.  Along with upward revisions to June and July, the +162k m/m increase in August Payrolls showed widespread, albeit mostly small, increases among sectors, with notable increases in Manufacturing and Construction.  Payrolls in Leisure and Hospitality had the largest swing, rebounding 62k in August after falling 21k in July (mostly in restaurants).  Excluding Leisure and Hospitality, Private Payrolls rose 65k in August after +92k in July.  These are solid gains in this low job-creation environment. 

The Household Survey confirmed the strength seen in Payrolls.  The Unemployment Rate was steady at a low 4.1%.  The broadest measure -- U-6 -- fell 0.2% point m/m to 7.7%.  Both Civilian Employment and Labor Force rose.  The Labor Force Participation Rate jumped to 61.6% from 61.4%, after having been in a downtrend since November 2025.  The increase could reflect the small sample bias of the Household Survey.  So, an upturn has to be confirmed over the next few months.  However, it raises the possibility that an improving labor market is encouraging people to resume looking for jobs.

Besides the Payroll strength, the 0.1 Hour increase in the Nonfarm Workweek to 34.4 Hours shows better activity in the economy.  Total Hours Worked (THW) rose 0.3% m/m in August, putting it 1.8% (annualized) above the Q226 average.  THW rose 1.2% (q/q, saar) in Q226.

The 0.3% m/m increase in Average Hourly Earnings (AHE) in August supports the Fed's view that the labor market is not producing inflationary pressures.  AHE has averaged 0.3% m/m since the start of 2025.

Trump's call for the Fed to lower the funds rate threw another wrench into the monetary policy debate, doubling down in a sense on Treasury Secretary Bessent's previous announcement of a shift out of long-dated government financing.  Trump's call is puzzling, since it is a widely held belief that Presidential jaw-boning could backfire by pushing Fed officials to act in an opposite way to assert its independence.  Perhaps Trump wants to disassociate himself ahead of the midterms from a tightening decision that may happen this month.  Whatever the motivation, his jaw-boning is not likely to have an impact on the Fed.  Fed officials' views of the economy should be the deciding factors.