Bottom Line: The Fed is walking a fine line here. Despite disinflation trends, it has proven difficult to keep rates from rising in the absence of softer growth data. It’s not evident, however, that the Fed wants conditions any tighter, but at the same time sending that signal could backfire in the form of higher inflation expectations. Without a catalyst to refocus market participants on downside risks to the economy, there looks to be room for rates to break still higher

The Fed’s Forecast is at Odds with Reality
at the time of the July meeting, the Fed anticipated growth would continue to slow, and below trend growth is a prerequisite to restoring price stability. Second, the Fed’s growth forecast is quickly turning into a complete disaster.
I think we need to have an honest but harsh conversation about the second point in particular. The Fed’s GDP forecast in the June SEP was at best dead on arrival, and at worst simply ludicrous. It implied basically no growth for the second half of 2023, which was plainly wrong even at that time. It required a sudden stop in the economy that just clearly was not happening when those forecasts were made. That forecast was in June, at which point the Fed staff should have known with almost 100% certainty that growth wasn’t falling off the cliff.
Before the Fed minutes were released, the Atlanta Fed raised its estimate of Q3 growth to 5.8%. Even if the reality is half that number, it’s still a major forecasting error on the Fed’s part, and we have been pounding the table for weeks that the Fed has completely underestimated the strength of the economy. Granted, I understand in theory I might need to eat my words on that at some point, but I feel pretty safe for now given that we are already halfway through the third quarter with no sudden stop evident. And if growth is that fast in Q3, I suspect it will retain that momentum in Q4 and put a January rate hike on the table.

Despite what looks like still solid growth in Q3, low inflation keeps the Fed on track for holding rates steady at the September FOMC meeting. I think the growth will be strong enough to keep another rate hike in the SEP and that more likely than not, the Fed will deliver that hike at the Oct/Nov meeting.

....If You Don’t Have Time This Morning
Despite what looks like still solid growth in Q3, low inflation keeps the Fed on track for holding rates steady at the September FOMC meeting. I think the growth will be strong enough to keep another rate hike in the SEP and that more likely than not, the Fed will deliver that hike at the Oct/Nov meeting. That said, I suspect the Fed also worries that policy is getting too tight, and hence we get mixed messaging that “maybe we need another hike, but rate cuts will be on the table in 2024.” The Fed can’t let policy become too tight if it wants to stick the soft landing, but I don’t think it can change its reaction function without letting inflation expectations rise. I don’t think sticking the soft landing will be as easy as the consensus increasingly appears to suggest.

The Fed will raise interest rates 25bp at this week’s FOMC meeting. The outcome of this meeting was effectively determined at the June meeting, something the Fed will deny but has been plainly evident in the signaling in the subsequent weeks. There has been no pushback against market pricing whatsoever during the intermeeting period, and the Fed doesn’t like to surprise markets. Moreover, failure to follow through on a rate hike would be equivalent to a substantial easing of financial conditions. It would rewrite the narrative around the path of monetary policy and bring forward rate cuts

...Monday Morning Notes, 7/24/23
The press conference is an opportunity for Powell to clarify the Fed’s reaction function. The Fed will discuss the conditionality around the timing and extent of further rate hikes at this week’s meeting. We think that Powell will lead market participants to broaden their focus beyond the inflation numbers by explaining that for the Fed to be confident it will restore price stability, it needs to see further cooling in demand evidenced by GDP growth slowing substantially, softer job growth, and further downward pressure on wage growth.

As might be expected, Premier Li also said at the meeting that stabilizing the real estate sector is one of the priorities of governments at all levels for H2 2023.

The State Council has solicited ideas from megacities such as Shanghai and Beijing. As both cities reported double-digit growth in real estate investment and new home sales in H1, the State Council will not adopt a national real estate stimulus policy, but will rather support first, second, and third tier city efforts to improve city-specific policies according to individual situations.

...As might be expected, Premier Li also said at the meeting that stabilizing the real estate sector is one of the priorities of governments at all levels for H2 2023.
The State Council has solicited ideas from megacities such as Shanghai and Beijing. As both cities reported double-digit growth in real estate investment and new home sales in H1, the State Council will not adopt a national real estate stimulus policy, but will rather support first, second, and third tier city efforts to improve city-specific policies according to individual situations.
In order to support the real estate sector in super-large and mega cities, the State Council also just ordered all 21 of these cities to promote the construction of both “Emergency and Dual Use” facilities in H2 2023, recreational facilities that can be used also in case of pandemic and emergencies. The State Council also ordered all 21 super-large and mega cities with a population greater than 5 million to speed up the transformation of the lower income “cities within cities,” to ensure the stability of the national real estate industry in H2 2023.


In order to support the real estate sector in super-large and mega cities, the State Council also just ordered all 21 of these cities to promote the construction of both “Emergency and Dual Use” facilities in H2 2023, recreational facilities that can be used also in case of pandemic and emergencies. The State Council also ordered all 21 super-large and mega cities with a population greater than 5 million to speed up the transformation of the lower income “cities within cities,” to ensure the stability of the national real estate industry in H2 2023...

...Going straight to the numbers, fiscal spending for H2 was bumped up from the original budget and is targeted to increase by just under 7%, 6.9% to be precise, from H1 spending.

In H1 2023 China’s fiscal spending rose 3.9% over the same period last year, to 13.39 trillion yuan. This 13.39 trillion-yuan figure, comprised of 1.67 trillion in central government spending and 11.72 in local government spending, represents 48.7% of the total 27.51 trillion yuan allocated for 2023, leaving 14.12 trillion yuan for H2 spending.

Thursday’s CFEAC meeting approved an additional allocation of 200 billion yuan to H2 2023 spending, to bring the total spending for H2 to 14.32 trillion yuan, about 7% higher than fiscal expenditures for H1. The extra 200 billion yuan also symbolically bumps year-on-year comps by more than 1 trillion above the 13.17 trillion that was spent in H2 of 2022, by 1.15 trillion to be precise.

The CFEAC predicts that these levels of spending will pull China’s H2 GDP growth into the 5.3-5.5% range.

The additional 200 billion yuan will be allocated as follows: 11.5 billion to subsidize targeted semiconductor and artificial intelligence enterprises, 52.5 billion to advance the “transformation of villages in super-large and mega cities,” essentially urban slums, 55 billion to spur the private economy, and 81 billion towards stimulating consumption. Local governments are urged to encourage more nongovernmental investments, including in integrated circuits, new materials, and next-generation information technology.

The CFEAC meeting stressed that fiscal policy should also be used to extend the duration of temporary policies such as value-added tax relief for micro and small-scale taxpayers.

Premier Li Qiang pledged an additional 46.5 billion yuan towards meeting the country’s “Made in China 2025” high tech objectives, of which 35 billion yuan will come from the secretive “Premier Fund.”

As might be expected, Premier Li also said at the meeting that stabilizing the real estate sector is one of the priorities of governments at all levels for H2 2023.

...Conditions are falling into place for the Bank of Japan (BOJ) to tweak Yield Curve Control (YCC) again as the central bank takes its first tangible steps toward exiting a quarter-of-a-century-old easy policy equilibrium.

Since he landed back at the Bank of Japan (BOJ) in April as governor, Kazuo Ueda has been dropping clues about conditions under which he would change Japan’s monetary policy settings.

While at its policy meeting last month, Ueda and his BOJ colleagues held fast to their position that preconditions for changing interest rates had not yet been met, they have been less clear about what might prompt the BOJ to again widen the control cap on 10-year Japanese government bonds (JGBs).

The Bank reiterated that rates would stay put until inflation is stably and sustainably at 2%, and accompanied by wage rises.

Its July 27-28 forecast round will likely raise the fiscal 2023 (Apr-Mar) inflation projection above 2% from 1.8% in the April round, yet continue to show inflation slowing from fiscal 2024.

On YCC, when BOJ Deputy Governor Shinichi Uchida was asked about the possibility of a tweak, he said an adjustment would seek to maintain “easy monetary conditions, while taking into account (the) impact on financial intermediation and market function.” By failing to rule out the prospect of a tweak, Uchida in fact fueled speculation it was in the offing this month.

We have been warning that the BOJ might look to tweak its YCC policy again this meeting before it abandons the program later this year(see SGH 6/13/23; “BOJ: Ueda Games Exit Timing”)...

...While at its policy meeting last month, Ueda and his BOJ colleagues held fast to their position that preconditions for changing interest rates had not yet been met, they have been less clear about what might prompt the BOJ to again widen the control cap on 10-year Japanese government bonds (JGBs).
The Bank reiterated that rates would stay put until inflation is stably and sustainably at 2%, and accompanied by wage rises.
Its July 27-28 forecast round will likely raise the fiscal 2023 (Apr-Mar) inflation projection above 2% from 1.8% in the April round, yet continue to show inflation slowing from fiscal 2024.

The Fed will on average maintain hawkish rhetoric until well past the July FOMC meeting as it is committed to that next rate hike. In general, Fed speak this week has closely followed the message of the SEP. For example, Cleveland Federal Reserve President Loretta Mester said her rate projection was in the median or a little above and San Francisco Federal Reserve President Mary Daly who said “We’re likely to need a couple more rate hikes over the course of this year to really bring inflation.” Richmond Federal Reserve President Thomas Barkin added this after the report:
“Inflation is too high,” Barkin said Wednesday in Arnold, Maryland. “If you back off too soon, inflation comes back strong, which then requires the Fed to do even more.”
When Fed speakers say “inflation is too high,” they are referring to the year-over-year numbers. I suspect, however, that market participants will take their cues from the month-over-month numbers. The Fed’s focus on the year-over-year numbers allows it to maintain a hawkish bias, reinforce the case for a July rate hike, keep the Oct/Nov option open, and push back on expectations of rate cuts anytime soon, but market participants know that year-over-year measures often hide turning points evident in monthly changes. It will be hard to keep market participants focused on a hawkish bias if we get another soft inflation print. That puts more weight on the growth outlook to keep the threat of an Oct/Nov hike alive.
Bottom Line: Arguably, today’s inflation print is only one number, but assuming it becomes a near term trend, the Fed will be more challenged to keep hiking rates after July. This is especially the case given its view that falling inflation creates tighter monetary policy. Being that I am optimistic on growth, I still see the story for another rate hike after July, but realistically the bar is higher after this inflation print. Still it’s a long time until the Oct/Nov meeting. We will need to wait and see how growth, employment, and wages evolve in the months ahead to tell us if any near-term disinflation is sustainable. And, of course, if inflation reverses course as it has in the past, the Fed won’t hesitate to keep the rate hike cycle alive. That said, in the near-term I suspect markets participants will try to run with the soft-landing story.

If You Don’t Have Time This Morning

With a July rate hike already priced in, the focus of market participants will be on what happens next. We will be looking for Fed speakers to give any hints that confirm or deny our baseline expectation that the Fed’s bias will lean toward hiking again after July if growth doesn’t slow more meaningfully.

...Market pricing has moved in our direction in recent weeks. Encouraged by strong data despite expectations of softer inflation numbers, market participants now expect roughly another 1.5 rate hikes this year while yields across the curve have largely retraced the post-SVB declines.
If inflation softens as expected, it may be challenging to take yields up another leg. Although I have high confidence in another rate hike after July, it’s hard for markets to price that in ahead of the supportive data. The Oct/Nov meeting is a long way off with lots of data between now and then.

The Fed staff are pushing a dovish message up to the Board members. It’s hard not to see this research as an effort to warn that the lagged impacts of policy will soon catch up to the economy. In the last two weeks, Fed staff have published notes saying excess savings in the US has been depleted and presumably then it no longer serves a cushion for the economy, that the percentage of financial distressed firms is at a high level, making capital spending and employment vulnerable to tighter financial conditions, and have rolled out a new financial conditions index which estimates that current conditions will drag down GDP by 0.75 percentage points over the next year.

The Fed staff look to be priming the Board to expect soft data, which creates an opportunity if the data is not soft.

If You Don’t Have Time This Morning
We anticipate the Fed will raise rates again at the July FOMC meeting and think it likely that either growth or inflation won’t soften enough to prevent a hike at the Oct/Nov meeting. The Fed tends to remain hawkish for longer than market participants anticipate, and this will especially be the case given the costs of being wrong, again, on inflation.

More of a Skip Than a Pause

The FOMC passed on the opportunity to raise rates today, as expected, and issued a hawkish set of projections with a terminal rate of 5.625%, a full 50bp higher than the March projections. We take this projection at face value and are penciling in rate hikes at the July and Oct/Nov. meetings.

CPI Report Supports Fed Skip
The CPI report doesn’t have enough juice to keep the Fed from holding policy rates steady when it’s two-day FOMC meeting concludes tomorrow. It’s sufficient, however, to keep the Fed’s focus on hiking again in July, making this meeting a skip rather than a pause. There’s a tension in the data between the measures of underlying inflation which reinforces my suspicion that it will be hard for market participants to price in a rate hike past July even if the Fed more explicitly adopts an “every other meeting” strategy.

Fed leadership is going into this meeting looking to hold rates steady. A core group of hawks would like to convince the FOMC that it needs to keep pushing forward and while they still may be successful, they recognize that the best they might accomplish is billing this meeting as a “skip” rather than a “pause.” Making this credible will require clear communications via the statement, SEP, and press conference.

At the latest State Council Executive Meeting, Premier Li Qiang stated that the guiding role of government investment policy and incentives should be to effectively stimulate private investment. He called for a raft of policies to boost the healthy development of the real estate sector to be implemented, while boosting big-ticket consumption like automobiles and home appliances. Supportive policies including tax and fee cuts are still needed to extend the services sector recovery.

A divided Fed is sleepwalking into another rate hike at the June FOMC meeting. Fed leadership has directed us to expect the FOMC will stand pat at this next meeting and bill the move as a skip not a pause, but market participants aren’t ready to buy that story. In public appearances, Fed hawks are running circles around the doves and the latter’s’ insistence that they remain data dependent isn’t helping them build a case for not hiking in June. If anything, the opposite is happening as the data reinforce the case for a rate hike.

Tuesday Morning Notes, 5/30/23
Bottom Line: If Fed presidents and Board members continue with the “there is a lot of data to consider between now and the June meeting” theme, market participants will follow that at face value. We should assume that if, as a result, the market assigns high odds to a June hike, the Fed will be forced to follow through. Maybe the doves get “lucky” and nonfarm payrolls prints negative and markets will price out a hike, but then maybe it gets priced back in after CPI. If the Fed hikes under that scenario, the story will be that the hawks overran the doves again. Alternatively, if leadership doesn’t want to take a chance on the data and wants to skip this meeting as part of a policy strategy, which I believe is the preferred option, it will need to put people out in the public to take control of the story. The natural person on the schedule for that is Jefferson. And I think if he owns the skip story, the Fed will tap the press on the shoulder to ensure a signal boost. Either way, as we have said, we don’t think the Fed is done hiking. If not June, then most likely later again this year.

Threading the Needle
Bottom Line: Despite Powell’s guidance, we can’t say there is no chance the Fed will hike again in June. There likely will not be data to convince the hawks that the Fed shouldn’t hike but could be data that forces Powell back to the rate hike camp. But the consensus at the Fed is trying to look through the data, and Powell appears to be in that consensus. In response, the hawks are setting up a fallback position that sets up a rate hike in July. The stronger the data, the more likely they will be successful.

Challenging Fedspeak
This leads me to suspect this next meeting is really not about the data. Sure, maybe some blowout numbers can influence the debate either way, but this meeting is about the ability of the dovish contingent to persuade the Committee that it should pause on the back of the policy lags story. The Fed has been floating the policy lags for months, the now is highlighted by banking stress. It’s getting to be time to fish or cut bait with that story. Either stick with the hawkish position of waiting for the inflation data to roll over, which given that inflation is a lagging indicator raises the risk of a hard landing, or make a play at the soft-landing by pausing while inflation remains elevated. That’s the choice here.

I think the consensus is moving in the direction of the doves. Dovish speakers are obviously emboldened, and I see signs that leadership leans in that direction as well. For example, when I see New York Federal Reserve President John Williams emphasize the lagged effects of policy and that supply and demand are in better balance and moving in the right direction, as he did in his comments to at the University of the Virgin Islands, I hear that he is ready to pause, and I don’t think Williams is going to go off-script. And I hear Federal Reserve Governor Phillip Jefferson giving the same message:

“…my reading of this evidence is that we are "doing what is necessary or expected" of us. Furthermore, monetary policy affects the economy and inflation with long and varied lags, and the full effects of our rapid tightening are still likely ahead of us.”

I think we need to pay attention to Jefferson as he is slated to be the next Vice Chair. He isn’t going to go off-script either.

If You Don’t Have Time This Morning

The Fed will likely hold rates steady at the June meeting as it weighs the impact of banking stress on credit creation. Still, the Fed retains a hawkish bias, and the risk is that the Fed hikes again. Indeed, I suspect the Fed is happy if market pricing for June reflects this bias. Still, even if the Fed expects another hike is more likely than a cut, and very much doesn’t think it will be cutting rates this year, the risk that the Fed will need to cut rates sharply to stabilize the banking sector dominates market pricing after June. There is little the Fed can do about this situation other than wait for the market to move in its direction.

Monday Morning Notes, 5/1/23
If You Don’t Have Time This Morning
The Fed will push policy rates up another notch this week to 5.125%. Although the Fed will likely keep the option for another hike in June open, there is growing pressure from the doves to bring this cycle to an end. The hawks are still trying to keep the Fed on notice that inflation has not yet been vanquished, but they are working against growing concerns of an emerging credit crunch. With policy rates likely in restrictive territory at the end of this meeting, any further moderation in demand or inflation will help make the case that policy is now “sufficiently” restrictive to restore price stability.

... We don’t think the Fed will decisively signal an upcoming pause at the June meeting. We think the tone of the meeting statement and presser will send the signal that policy rates are in restrictive territory but might not yet be sufficiently restrictive to return inflation to 2% over a reasonable time horizon. Given the tendency of the inflation data to surprise the Fed on the upside, Fed Chair Jerome Powell gains little by taking a June hike off the table when he can just lean on the March SEP and say, “seven participants believed in March that rates still needed to move higher, and those projections will be revised in June.” That would put the odds in favor of a pause but leave open a non-trivial probability of a rate hike.

...Any further rate hikes will be heavily dependent on the data flow and the Fed’s assessment of credit conditions. Whereas even last fall one could say that the Fed still had a long way to go before rates were in restrictive territory, that is no longer the case. Appetite for additional rate hikes is waning among FOMC participants, and even the hawks will eventually embrace the policy lags argument. We are likely seeing the last gasps of the hawks as we circle around the end of this cycle.

With Japan’s wages continuing to lag prices and core CPI likely to slow to 1.6% over the next year, newly minted Bank of Japan (BOJ) governor Kazuo Ueda will be looking beyond his first meeting on April 27-28 to change policy.

The upcoming forecast round by the BOJ will feature fresh quarterly growth and inflation forecasts extending through fiscal 2025.The update may plot a path back to the 2% goal in 2025.

The BOJ expects Japan’s current 3% inflation rate to slow to below its 2% target in the latter half of this coming fiscal year.

CPI data due out April 21 is expected to show core inflation around 3%, little changed from February and with global growth set to pick up after a period of slowdown, and Japan’s wages to continue to rise.

Against that backdrop Ueda is eying an appropriate time to make a move on exiting the BOJ’s yield curve operations.

The sequence will likely be a tweak to yield curve control (YCC) in June as the technocrats simultaneously work on a framework that allows them to review, and then exit YCC, altogether thereafter.

The BOJ’s rates outlook is an entirely different contemplation, and we don’t see the BOJ raising its official rate this year.