Fed Easing on Track, Fiscal Policy An Issue?

The Fed's implicit promise to ease monetary policy in order to sustain economic growth -- as long as inflation remains muted -- stands as a strong positive for the stock market.  However, some profit-taking could weigh on the market this week after the market rallied ahead of and on Fed Chair Powell's speech in which he finally confirmed a September rate cut -- a "buy the rumor sell the fact" pattern.  The market will probably now focus on whether and by how much the Fed will cut rates after the September FOMC meeting.  With the Fed now emphasizing risks to economic growth, real-side economic data should become more important than inflation data.  

Inflation data are still important, nonetheless, as they need to confirm their downtrend to satisfy the Fed and markets.  The consensus expectation of 0.2% for both Total and Core July PCE Deflator, due on Friday, should be acceptable and taken in stride.  Stocks would likely rally on a smaller increase.  The latter can't be ruled out.

The Fed's policy stance should restrain any downside risk stemming from policies of a new Administration, whether it be Democratic or Republican.  Many of the proposals relate to re-distribution rather than economic growth.  So, they may have little significance for monetary policy.  However, some policy proposals could be significant for the Fed at some point.

The Democratic proposal to hike the corporate tax rate may have macroeconomic effects.  If the tax reduces profits, it could dampen business investment as some projects become unprofitable.  If the tax is passed through to prices, there would be a temporary boost to inflation that would cut consumer purchasing power.  If the tax is pushed down to labor, resulting in lower-than-otherwise wages, consumer purchasing power would be hurt, too.  However, if, as theory says would happen, workers in non-corporate businesses also receive lower-than-otherwise wages, these companies could pass through the lower labor costs to prices, offsetting at least to some extent the hit to purchasing power from the tax.

Harris' plan to extend Biden's cap on drug prices would seem to help hold down inflation.  However, it may prompt pharmaceutical companies to raise prices on other drugs.  Also, it could lead to shortages and higher prices through a black market for the capped drugs. 

The Republican proposal to hike tariffs should boost prices, at least initially.  In principle, however, they should be offset by a stronger dollar so the boost may be less than expected.  Whether tariffs result in only a one-time increase in prices or feeds into a sustained increase in inflation may depend on whether wage rates move up in response.  This won't be seen immediately, but could make Fed policymakers cautious about the inflation outlook.

Trump's wish to participate in Fed rate decisions is not good.  Participation by a president risks preventing the Fed from tightening to prevent inflation, a politically unpopular policy.  This risk could undermine global confidence in the dollar, causing the latter to fall in the FX market.  This would be inflationary. Between a loss of confidence in the Fed's inflation-fighting ability and a weaker dollar, inflationary expectations would rise, resulting in a steeper Treasury yield curve (higher long-term yields) -- a negative for economic growth.

Both parties appear to want to increase the Child Care Credit.  This would boost consumer spending.  And, unless it leads to a significant increase in labor force participation, would need to be "crowded out" either by market moves or Fed policy if the economy is close to full employment.

Dovish Speech At Jackson Hole?

The stock market should continue to be buoyed this week by expectations of a dovish speech by Fed Chair Powell at the Jackson Hole conference on August 24-26.  He is likely to acknowledge progress against inflation while economic growth has remained solid.  He may indicate that the Fed will soon be ready to pull back gradually from a restrictive monetary policy stance in order to sustain this growth, given that policy changes often are mentioned at this conference.

Last week's US economic data supports a gradual relaxation of monetary policy.  While the inflation data were good, they were not altogether soft.  The real-side data were mixed, but overall consistent with another quarter of growth.

Stocks rallied sharply on the low July PPI headlines of +0.1% m/m Total and 0.0% Core.  But, these were held down by the volatile, if not questionable, Trade Services component.  Core Ex Trade Services rose 0.3%, matching its average over the first half of the year.  It suggests steady inflation ahead.  

Stocks paid less attention to the July CPI, which came in as expected at 0.2% m/m for both Total and Core.   The measure favored by Powell -- Core Less Shelter -- was even better at 0.0% for the third month in a row.  However, Shelter sped up, with Primary Rent rising  0.5% after 0.3% in June and Owners' Equivalent Rent at 0.4% after 0.3%.  Although the speedups could be just offsets to the below-trend June prints, even an average of the two months would argue against expecting rent to trend down.  A steady trend in the rent component of the CPI could make it difficult for the Fed to achieve its 2% inflation target.

Stocks rallied again on strong July Retail Sales.  There was little pullback from the June jump in sales, setting up the possibility of a speedup in consumer spending in Q324.  The July level of Ex Auto/Ex Gasoline Retail Sales is 4.0% (annualized) above the Q224 average.  This compares with a 2.9% q/q (saar) pace in Q224.  Also, the Unemployment Claims data are leaning to a stronger labor market.  Initial Claims fell below the July average in the past two weeks.  Although Friday's release of July Housing Starts showed a large m/m drop, it seems to be largely weather related.  The bulk of the drop was in the South, which had been hit by large storms.

The Atlanta Fed model's projection of Q324 Real GDP Growth is now 2.0% (q/q, saar).  This could change as more data come in.  As it stands, it is in line with the Fed's estimate of the longer-term trend in the economy.  And, from the Fed's perspective, a highly desirable pace that should allow for some easing in monetary policy.

 

 

Stock Market Helped By US Economic Data This Week?

The stock market could be helped by this week's US economic data, which should point to moderate economic growth and inflation -- either in the headlines or once volatility is smoothed out.  Consensus is likely to coalesce around a "measured" pace of 25 BP rate cuts by the Fed beginning in September.  Fed Chair Powell could discuss such an approach at the Jackson Hole Conference (August 24-26).  Anticipation of his speech could help lift stocks this week.

Normal volatility or one-off events, like bad weather, could look like recession when the economy is growing near trend.  The 1.7-2.0% estimate of longer-run growth estimated by the Fed is close enough to zero to make large negative shocks look as if the economy is moving into recession.  More than one month's reports are needed to confirm the latter for this reason.  

Similar considerations apply to inflation data, for which volatility could mask the underlying pace.  Volatility is a risk in this week's July CPI.  The consensus estimate of +0.2% m/m for Total and Core would be favorable prints, nudging down the y/y by 0.1% pt for each.  However, there is a risk of a 0.3% Core from a rebound in Airfares.  Seasonal factors look to offset a large drop in airfares in July.  Their drop in June suggests airlines may have pulled ahead this seasonal weakness, which helped hold down Core CPI to 0.1% that month.  If so, airfares could rebound in July, possibly resulting in a 0.3% Core.  The market will likely discount an above-consensus Core CPI print if this is the reason.  Averaging the two months would give the right measure of underlying core inflation.  And, a 0.2% average would be Fed and market friendly.

Taking account of volatility may be important to understand the July Retail Sales Report.  Consensus looks for a slight increases of 0.1% m/m in Ex Auto Sales.  This follows +0.4% in June.  The market may view a small increase as a sign of weakening consumer.   But, this is not necessarily so.  More importantly, Ex Auto/Ex Gasoline Sales jumped 0.8% in June.  So, a modest increase or even a decline in July would be a typical print after a large gain.  It still would point to decent consumption growth in Q324.  

Curiously, the Atlanta Fed model's latest projection is for a strong 2.9% (q/q, saar) in Q324 Real GDP Growth, despite all the market angst about recession.  The model estimate can change as more data come in.  And, the 3.0% estimate for Q324 Consumer Spending seems a little high.  However, at this point, the model translates the latest data into another quarter of above-trend growth.

A Potential Recession, But More Aggressive Fed?

The stock market may remain sensitive to evidence of a potential recession this week, after the Mfg ISM and Employment Reports surprised on the weak side.  There are few data releases this week, but a counter-consensus decline in the July Non-Mfg ISM could hurt the market.  The market may stay under stress until the Fed gives a clear signal that it will ease aggressively.  Fed Chair Powell will have such opportunity at the Jackson Hole Conference on August 24-26.  He could open the door for multiple or large rate cuts ahead.

The July Employment Report raised the risk of recession, but did not mean one is at hand.  In either case, the Report contained a number of elements that could encourage the Fed to ease more often than just in September or start with a 50 BP rather than 25 BP cut without fear of stoking inflation.  Whether the Fed chooses to begin with a 50 BP rate cut could depend on what prints in the August Employment Report, due September 6.  It's too soon to estimate, but a speedup is conceivable to the extent bad weather temporarily hurt job growth in July.

Although the market viewed the below-consensus +114k m/m increase in July Payrolls to be particularly weak, the truth is it is consistent with trend labor force growth based on a steady Participation Rate.  The Fed is probably happy with this pace of job growth, seeing it not recessionary but sustainable in the long run.

Indeed, the composition of the m/m change in Nonfarm Payrolls raises the possibility that weak demand was not the main reason for the modest overall increase.  Most of the weakness was outside of cyclical sectors -- instead, in service-producing sectors, such as professional and business services (particularly accounting and administrative), finance and insurance, and private education.  Cost cutting and maybe the substitution of AI for workers may have been behind the job cuts.  If so, productivity (and earnings) will likely improve.

A decline in Total Hours Worked (THW), thanks to a lower Nonfarm Workweek (possibly weather related), suggests Real GDP Growth should be under the long-term trend 2.0% in Q324.  THW in July are 0.5% (annualized) below the Q224 average.  Even if THW don't bounce back in August and September, productivity growth could keep GDP Growth positive.  So, the data don't necessarily mean a recession is imminent.

The 0.2% pt jump in the Unemployment Rate to 4.3% is consistent with sub-trend economic growth if not recession.  The jump, however, largely resulted from an increase in the Labor Force Participation Rate.  The Participation Rate rose in both June and July after dropping in May, and the July level is back to that seen in the Spring.  The 3-month swing could be just volatility, but the recovery in the Participation Rate should assuage any concern Fed officials might have had about the potential growth of the economy.  And, the higher level of the Unemployment Rate means the Fed has less to fear of stoking inflation by stimulating the economy.

The below-trend 0.2% m/m increase in Average Hourly Earnings supports Powell's comment, made at the post-FOMC Meeting news conference, that the labor market is not a significant source of inflation pressures.   Eight of thirteen sectors posted sub-0.3% increases, 0.3% being the recent trend.  The low pace needs to be seen in coming months, as well, to conclude that trend in wage inflation has ratcheted down.

Consensus looks for a rebound in the Non-Mfg ISM to 51.0 in July from 48.8 in June.  Perhaps, consensus is based on the idea that the survey would catch up to the bounce-back in Retail Sales in June.  In contrast, bad weather could depress it.  Also, the decline in the July Mfg ISM suggests downside risk.  However, the m/m correlation between the Non-Mfg ISM and Mfg ISM is not solid.  From the most recent experience, both moved in the same direction in 5 of 6 months in H124, suggesting a counter-consensus decline in the Non-Mfg ISM.  They did not track as well last year, though.  They moved in the same direction in only 7 of 12 months in 2023.  So, while the decline in the July Mfg ISM suggests downside risk to the consensus estimate, it is not necessarily reliable.

Relief for Stocks from FOMC Meeting and US Economic Data This Week?

The stock market may get some relief from this week's FOMC Meeting and key US economic data, although they are not expected to break new ground.   Steady Fed policy for now, but with rate cuts on the horizon is likely to be the message from this week's FOMC Meeting.  Powell could hint at a September rate cut, but he'll have another opportunity at the Jackson Hole Conference on August 24-26.  Key US economic data are expected to be in line with recent trends showing moderate growth.  As-expected outcomes of the Meeting and data still could help stabilize the market by underscoring the essentially positive macro background. 

The Fed is likely to keep open the door for rate cuts at this week's FOMC Meeting, but reiterate that it needs more evidence that inflation is trending down before deciding to ease.  July and August data will be available ahead of the September FOMC Meeting.  Total PCE Deflator would need to print 0.2% m/m on average in the two months to bring down the y/y from 2.7% in June by the time of the Meeting.  A 0.1% print for Core would keep the y/y steady at 2.6%. 

Recently, Powell highlighted an apparent slowdown in economic activity, providing another reason for a rate cut.  He may not back away from this possibility despite the above-trend 2.8% Q224 Real GDP.  Real GDP Growth was about 2.0% over the first half of the year, well short of the 3.2% 2023 pace.  He also may emphasize that the underlying Final Sales growth of 2.0% (in line with the Q124 pace) is near the longer-run trend.  

To be sure, this near-trend pace doesn't scream for easier monetary policy.  Indeed, the Q224 GDP composition highlights the stimulative force from government policy that Powell (probably for political reasons) hardly, if ever, mentions -- the strength of government purchases, both at the Federal and State & Local level and the strength in Business Equipment Spending, also seen in June Durable Goods Orders, likely reflecting in part government-induced spending on alternative energy and re-shoring of manufacturing from abroad.  So, while a September Fed rate cut is widely expected, it may need more supportive evidence -- perhaps both on the inflation and real-side fronts -- to happen.

The 0.2% m/m Core PCE Deflator in June was somewhat disappointing from the Fed's perspective.  Not as low as the June Core CPI, it matched the m/m increase in June 2023 and kept the y/y steady at 2.6%.  However, the unrounded m/m increase is 0.18%, so was within statistical noise of printing 0.1%.   So, the data will not likely change the Fed's expectation of a downtrend in inflation.  

This week's July Employment Report may reinforce the view that economic growth is solid but still leave open the door for a September rate cut.  Consensus looks for a slight slowdown in Total Nonfarm Payrolls, to +185k m/m from +206k in June.  Private Payrolls are seen speeding up to +155k, versus +136k in June.  Despite the speedup, a sub-200k Payroll print may be soft enough to be viewed positively by the Fed and markets.  Consensus looks for benign prints for the other important parts of the Employment Report.  It sees a steady 4.1% Unemployment Rate and a trend-like 0.3% m/m increase in Average Hourly Earnings.

 

More Downward Pressure on Stocks?

The stock market could remain under pressure from this week's US economic data, but not necessarily as the risks favor friendly prints.  The week's two key pieces of US economic data are the June PCE Deflator and the first-print of Q224 Real GDP.  The consensus estimate of the PCE Deflator is not entirely friendly, as it exceeds the low print seen in the June CPI.  But, consensus risks being too high. Real GDP could be problematic -- the low consensus GDP estimate is a positive for the Fed, but the high Atlanta Fed model estimate is not.  

The consensus estimates for the PCE Deflator -- +0.1%  m/m Total and +0.2% Core -- seem too high,  given the low June CPI (-0.1% Total and 0.1% Core).  Re-weighting the CPI components and taking account of some PPI components suggest the PCE Defllator could be 0.1% pt lower than consensus for both Total and Core.  The y/y would fall for the Total PCE Deflator even with the consensus estimate.  The y/y for Core would be steady with the consensus estimate, but decline if the downside risks materialize.

Consensus looks for 2.0% (q/q, saar) Q224 Real GDP Growth, which would be in line with the Fed's estimate of the longer-run trend and be an acceptably modest pace from a monetary policy perspective.  However, the Atlanta Fed model currently estimates 2.7% for Q224 Real GDP, which would be too high for the Fed.  (The estimate is updated one more time on Wednesday.)  Above-trend growth removes a reason to cut interest rates.   The best that could be said about the Atlanta Fed model estimate is that it would put the H124 Real GDP pace at 2.0%, averaging 2.7% with the 1.3% growth in Q124.  The H124 pace would be near the bottom of the 1.9-2.3% Fed's Central Tendency Forecast for 2024 and in line with the longer-run trend estimate.   Nevertheless, an Atlanta Fed-like print would probably be viewed negatively by the stock market for being too high from the Fed's perspective.

Labor market data are more supportive of the consensus GDP estimate than the Atlanta Fed model's.  First, Total Hours Worked rose 1.6% (q/q, saar) in Q224, versus 0.9% in Q124.  Second, the increase in the Unemployment Rate over Q224 suggests below-trend economic growth, even taking account of lags between growth and the Rate. 

Last Wednesday's sell-off can be explained a number of ways, including the above-consensus prints of almost of all of the week's real-side data -- mentioned as the risks in last week's blog.  One explanation that may resurface is the impact of political decisions stemming from November elections.  The Democrats and Republicans have different agendas, but both are potentially problematic for the economy and stock market.

The press blamed the sell-off in tech stocks on a Bloomberg story about the Biden Administration considering tighter restrictions on chip sales to China.  Tighter restrictions clearly would be a negative for the impacted companies.  The effects would be broader if China takes retaliatory measures.  To be sure, tighter chip restrictions now are just a possibility, and the leak of their consideration conceivably may have aimed at squashing them.

The Trump approach to China (and the rest of the world) appears to be the imposition of 100% tariffs.  This could have several effects.  It would be a clear negative if other countries respond by imposing tariffs on US exports -- a rehash of the Smoot-Hawley Tariff Act of 1930, blamed for worsening the Great Depression.  If other countries don't respond, the dollar should appreciate to a point that offsets the tariffs (to the extent they are passed through fully or partially) -- with no ultimate impact on prices or  economic activity.  However, if foreign companies relocate to the US to beat the tariff, their demand for factories and workers could prompt the markets to crowd out other, domestic, activities in the US.  There would be little net positive effect on overall US economic activity.  Instead, it would lower the US standard of living, as producing goods domestically would be more costly than what had been done abroad.

Corporate Earnings and Real-Side Data Next

The stock market may turn cautious going into the Q224 corporate earnings season.  The macro background was not as supportive as in prior quarters, suggesting there could be more mixed reports (see my June 30 blog).  

The market also will be looking for more evidence arguing for a September Fed rate cut.  After highly favorable inflation data last week,  real-side data for June will be featured this week.  The market will  look for weakness, with Fed Chair Powell having highlighted a growing concern about the possibility of a significant economic slowdown.  Consensus estimates support the idea of slower economic growth.  However, stronger prints in some cases can't be ruled out, which could disappoint the market.

The most important report is for June Retail Sales.  The consensus estimate of 0.0% m/m Total and +0.1% Ex Auto would be the third straight month of sluggish sales.  The risk is that the soft prints for April and May were just the typical pause after a strong month, in which case a third such month is less likely although not unprecedented.  Lower-priced gasoline sales need to be taken out to judge the underlying pace of sales.

Another report that risks exceeding the consensus estimate is June Industrial Production.  Consensus expects 0.3% m/m, versus 0.7% in May.  However, there is upside risk, as Total Hours Worked in Manufacturing rose 0.5% m/m in June, after +0.8% in May.  

Consensus looks for an uptick in June Housing Starts to 1.31 Mn Units after dropping to 1.28 Mn in May.  However, this pace still would be soft, as the June level would be lower than the 1.33 March-April average.   Consensus also expects a dip in June Housing Permits to 1.39 Mn Units from 1.40 Mn in May.  Although Permits tend to lead Starts and Starts lead residential construction activity, there is still residual strength in the latter.  Total Hours Worked in Residential Construction rose in May and June, possibly resulting from the strength of earlier Starts.  

The June CPI was very good news for the Fed.  Importantly, Primary and Owners' Equivalent Rent broke below their recent trend, possibly beginning, at last, to catch up to the flattening in rents shown by private surveys.  If this slower pace continues, the Fed's 2% inflation target is eminently achievable.  The report moves the evidence closer to a Fed rate cut in September.