Inflation And The Fed

The stock market may continue to be weighed down by concerns regarding AI, Iran war and the Fed this week, after last week's data releases underscored a persistent inflation problem.  From the Fed's and market's perspectives, the question is whether non-economic factors -- AI, tariffs and Iran war -- are behind the high inflation prints and whether the impact from these factors will dissipate over time.  If this is the case, then a gradual approach to tightening would likely be appropriate.  A breakdown of the September CPI suggests these factors are playing a significant role but may not be the whole story.  It remains an open question whether the Fed will engage in only modest additional tightening after skipping a rate hike at the October 27-28 FOMC Meeting.

The high September CPI (+0.6% m/m Total and +0.3% Core) showed widespread price increases.  Two-thirds of the major Core components had increases that exceeded their prior 3-month average.  They appeared to be high for a variety of reasons, including AI, tariffs and the Iran war.

Some of the large price increases were just catch-up after declines or flat prints in prior months or by components that are typically volatile.  For example, a 2.0% jump in the volatile Lodging Away From Home -- all because of a boost from seasonal factors -- contributed a notable 0.04% pt to the Core CPI.  However, there is more to the story than just volatility in some components.  The Cleveland Fed's Trimmed Mean CPI -- which eliminates outliers -- sped up to 0.3% m/m from 0.2%.    

Many price increases could have resulted from AI-related shortages, e.g., computers (higher-priced memory), or from the jump in oil prices, e.g., airfares, intra- and inter-city transportation, delivery services and more.  The impact of higher oil prices, in particular, can lift the prices of a broad range of goods and services.  Fear of renewed fighting in the Iran war after the midterm elections should keep oil prices up for at least the next few weeks.  Computer memory prices, in contrast, appear to be falling gradually -- a good sign that the shortage is abating. 

AI is typically viewed as leading to higher productivity growth -- which would hold down inflation.  However, in the current early stage of AI adoption, firms may be using AI without reducing headcount.  They may be introducing AI cautiously.  With AI costly to use, it may be a factor lifting prices for now, as it may not be being offset by lower wages for some companies.  To be sure, AI could be a factor behind the recent slowdown in wage inflation.  (Average Hourly Earnings slowed to an annualized 2.4% in Q326 from 3.3% in the prior 4 quarters.)  With companies pulling back on hiring, either because AI substituted for labor or because of uncertainty about how AI will affect their need for workers, the ensuing weaker labor demand could be weighing on wage inflation.

One troubling speedup in the September CPI, not directly impacted by the non-economic factors, was Owners' Equivalent Rent (OER), which has a high weight in the CPI.  It reverted back to trend, rising 0.3% m/m in September after slowing to 0.2% in August.  The Core CPI would have rounded to 0.2% in September if OER rose only 0.2% and Lodging Away From Home was flat.  The trend in OER needs to slow to 0.1-0.2% for the Fed to achieve its 2% inflation target on a sustained basis.  If it does not, other prices need to slow below an annualized 2% pace to achieve the Fed's target -- arguing for more aggressive Fed tightening that would weaken economic activity.  To be sure, Primary and Owners' Equivalent Rent could be affected indirectly by oil prices to the extent that the latter is behind the rise in longer-term yields including mortgages.  A shift away from home ownership to renting as a result of the higher mortgage rates could put upward pressure on rents.  An end of the Iran war could lead to lower rents that help to hold down the CPI.

From the Fed's perspective, what's most important is preventing higher oil prices, because of their pervasive impact, from sparking a wage-price spiral.  This consequence does not appear imminent, despite the recent rise in inflation expectations, as wage inflation looks to be contained if not slowing.  So, the Fed can afford to skip hiking rates at the October FOMC Meeting if it wants and then resume tightening gradually at subsequent Meetings.  

 

 

 

 

 

This Week's Important US Economic Data

The stock market will face some important US economic data this week as a strong corporate earnings season gets underway.  Consensus expectations for the September CPI and Retail Sales, among other relevant but minor data, show that inflation remains high overall and sticky in the core as well as a continuing solid consumer.  This picture keeps open the door for more Fed tightening.  However, a consensus print for Core would likely allow the Fed to skip hiking rates at the October FOMC Meeting -- which would be a near-term positive for stocks.

Consensus looks for +0.6% m/m Total CPI and +0.2% for Core.  These estimates look reasonable.  Retail Gasoline prices jumped about 9% (sa) in September, which largely accounts for the jump in Total.  The higher gasoline prices could permeate through Core components, as well.  However, seasonal factors begin holding down Airfares this month after boosting them in the prior three months.  Seasonals boost Lodging Away From Home for the second month in a row, and this component could jump similarly to its 2% bound in August.  All these considerations add up to about 0.2% Core.  Nonetheless, the consensus estimate of an uptick in the y/y to 2.5% from 2.4% may be too high, depending on rounding.  An un-rounded m/m Core of 0.22% or lower would result in a steady 2.4% y/y, which the stock market may like.

Consensus looks for only a modest slowing in Retail Sales in September after they jumped in August.  Total Sales are seen up 0.3% m/m after +1.2% in August, while Ex Auto is seen +0.5% after +1.4%.  There is no consensus estimate for Auto/Ex Gasoline Sales, which jumped 1.2% m/m in August.  Even a modest increase in the latter would be notable, since a large increase can be followed by some payback in the following month.  At this point, Real Consumption looks to have expanded well over 3.0% (q/q, saar) in Q326 -- despite the weakness in surveys of consumer sentiment or confidence.

The University of Michigan Consumer Sentiment Index fell for the third consecutive month according to the Mid-October print reported Friday.  The weakness was in Current Conditions.  Importantly from the Fed's perspective, the longer-run 5-year Inflation Expectations measure rose to 3.5% from 3.4%, the highest since May and remaining above the pre-Iran war range of 2.8-3.2%.  It is not a good print from the perspective of the inflation hawks at the Fed.

 

Corporate Earnings and Fed Policy -- Near-Term Positives

The stock market may be buoyed in the next few weeks by two expectations -- strong Q326 corporate earnings and steady Fed policy at the October 27-28 FOMC Meeting.  These positive expectations could be tempered by a rise in longer-term Treasury yields.

 Corporate Earnings

Consensus looks for another quarter of huge earnings growth.  S&P 500 corporate earnings are expected to climb 23-29% (y/y) in Q326, lifted by strength in Information Technology and Energy.   This follows earnings growth of about 50% in Q226 and 28% in Q126.  The macroeconomic data support the idea of still strong earnings but not as strong as in Q226.  Real GDP Growth is seen slightly slower in Q326 than Q226 on a y/y basis.  Oil prices are still up sharply but not as much as in Q226.  The FX value of the dollar is a bit softer, making earnings abroad worth more in dollars, but not as much as in Q226 -- although this could be offset by an improvement in economic activity abroad in Q326.  Profit margins don't look to have improved, as the spread between the Core CPI and Average Hourly Earnings was steady after expanding in Q226.  

                                                                                                                                        Euro  Area   

                  Real GDP     Oil Prices      Trade-Weighted Dollar    AHE     Core CPI    Mfg PMI  

                     [                y/y percent change                                                            ]          (level)

Q126            2.6               40.0                       -8.0                               3.6           2.5                50.6     

 

Q226            2.2 *            75.0                       -4.0                               3.3           2.7                51.7      

 

Q326            2.1 *            40.0                       -1.0                               3.1           2.5                52.4          

                                                                           

* Based on the Atlanta Fed Model's latest projection of 3.7% for Q226 (q/q, saar). 

 

Fed Policy and Latest Key Economic Data

 

Last week's softer-than-expected inflation and employment data lifted expectations of steady Fed policy at the October 27-28 FOMC Meeting, although these Reports should not have changed Fed views by much if at all.  The Reports still showed higher-than-desired inflation and a solid labor market.  Nonetheless, they provide reasons for the Fed to fall back on if it wants to avoid hiking rates just before the mid-term elections.  Indeed, recent comments by two top Fed officials -- the Fed Vice Chair and the NY Fed President -- suggest they are open to skipping a tightening in October, citing a need to wait and see more data.

 

Although the headline m/m prints for the August PCE Deflator were lower than expected, the underlying pace is still higher than the Fed's 2% target.  Along with the benchmark revisions to prior months, the 0.2% m/m increase in the Core PCE Deflator resulted in 3.0% y/y.  Moreover, the Core PCE Deflator was rounded down from 0.245%.  On an annualized basis, it was up 3.0%.  The annualized increase since December is 3.2%.  Note that the Core PCE Deflator has to average less than 0.22% m/m for the rest of the year to lower the y/y by December.  All these ways of evaluating underlying inflation should not dissuade the Fed from sticking with its hawkish tilt.  

 

Similarly, although September Nonfarm Payrolls rose only slightly, the weakness was probably not enough to convince the Fed to change its view of a solid labor market.  The Unemployment Rate remained within its recent tight range that is typically viewed as full employment.  The broadest unemployment measure of the labor market -- U-6- which takes account of part-time workers for economic reasons and people marginally attached to the labor force -- dipped.  And, Total Hours Worked are up 1.2% (q/q, saar) in Q326 -- a bit more than the 1.1% in Q226.  So, they are consistent with 2.0+% Real GDP Growth in Q326, taking account of productivity growth -- better than the Fed's longer-run growth estimate of 1.8-2.0%.  

The lower-than-consensus increase in September Payrolls ran counter to the speedup suggested by Unemployment Insurance Claims data.  The contradiction suggests that the slow job growth results from  weak hiring rather than increased firings.  This result appears to have been the case over July and August.  The JOLTS Data show that a 241k decline in Separations in the Private Sector over the 2 months (that is fewer layoffs) was partly offset by a 170k decline in Hiring.  This combination is unusual.  Typically, cyclical forces lead to increased hiring accompanying reduced firings.  AI may be holding back hiring?

The difficulty of finding a job (along with high gasoline prices) may be behind the recent decline in consumer confidence.  The Conference Board's measures of Jobs Hard To Get and Jobs Plentiful could provide clues whether job finding remains a problem or is beginning to improve.  

Higher Long-Term Treasury Yields

A possible Fed reluctance to tighten ahead of the mid-term elections in the face of still problematic inflation may be behind the latest run-up in longer-term Treasury yields.  The latter may be making up for Fed inaction to fight inflation.  Although a more aggressive Fed could bring longer-term yields down, it would hurt the economy and stocks.  The best development for both the Treasury and stock market (and economy) would be an ending of the Iran war than results in a drop in oil prices.