Monday Morning Notes, 4/11/22
If You Don’t Have Time This Morning
It’s full steam ahead for monetary policy with the Fed positioned to begin a series of 50bp rate hikes at the May FOMC meeting. At this point, we are waiting to see how the economy responds to the rate hikes already priced into markets. I am watching for the Fed’s reaction to any choppy data as there will be a limit to how many rate hikes it wants markets to absorb in the near term.
Recent Data and Events
Last week was light on the data, but there were a couple of noteworthy items, nonetheless. The Atlanta Fed wage tracker smoothed measure rose to 6.1%:
This strikes me as consistent with a roughly 4% underlying inflation trend. Again, these trends can stabilize but typically don’t reverse themselves absent a recession, meaning of course that if trend inflation is closer to 4% than 2%, the Fed will be faced with accepting elevated inflation or tipping the economy into recession with restrictive policy.
Balances on credit cards went vertical in recent weeks:
This speaks to my point that households have capacity to absorb higher prices via running down savings or taking on additional debt. This additional spending power can help limit the impact of the March inflation shock.
Upcoming Data and Events
This week will feature a much more interesting data flow. Tuesday, we get the eagerly awaited March CPI report. Wall Street expects to see a whopping 1.2% gain on the headline number and 0.5% on the core (the Cleveland Fed expects 1.11% and 0.52%, respectively). The explosion in headline inflation in March will feed into the story that the worst is behind us on a year-over-year basis. Further feeding into that story would be any downside miss on the core number attributable to falling used car prices, something foreshadowed by the Manheim index:
One inflation view is that inflation is primarily not a macro event, but a micro, supply side event. That view still holds onto a decline in used vehicle prices leading the way back to a primarily transitory inflation story.
While a miss on core driven by used prices would be welcomed by the Fed, I think overall the consensus at the Fed will lean towards caution. From a pure symmetry perspective, the fact that the Fed looked through the rise in used vehicle prices last year means it should look through any decline this year. More importantly though, no one expects inflation to remain running over 8% annually. The Fed still assumes that a large portion of the inflation surge will prove to be transitory and is watching for how much persistent inflation is left over at the end of this year. The issue is underlying trend inflation (as I noted earlier, I think wage growth is consistent with 4% underlying inflation). With that in mind, I think it is important to watch “supercore” inflation:
And measures that track the breadth of inflation pressures:
Two more points on this topic. First, although there is a focus on declining used car prices, we should be open to the possibility that category declines, yet core still meets or exceeds expectations. This would suggest a greater portion of the inflation surge is persistent in nature. Second, I wouldn’t dismiss any pickup in food inflation – we are at a juncture where that could feed into inflation expectations.
On Thursday, we get the retail sales report for March. Wall Street expects a 1% gain excluding autos and -0.1% for the control group. The Chicago Fed predicts a 3.2% decline excluding autos:
That suggests potential for a large downside miss, but still the Chicago Fed number hasn’t been a great guide the last few months. As I wrote last week, there is potential that a combination of the March inflation shock and a shift into services temporarily took the wind out of goods spending. A substantial downside miss would feed into the story that “the Fed is hiking into a downturn, recession is imminent.”
Other reports for the week include PPI, industrial production (watch the vehicle production numbers as supply issues look to still be a problem in that sector), and the preliminary University of Michigan confidence numbers for April. With respect to the latter, the focus should be on the inflation expectations components. The Fed will take comfort in a stable long-term number.
We also have a reasonable amount of Fed speak this week. The highlight will be soon-to-be Federal Reserve Vice Chair Lael Brainard’s moderated discussion of the economy on Tuesday. Also, from the Fed Board we will hear from Governors Christopher Waller and Michelle Bowman, both of whom will make brief comments at a Fed Listens event on Monday. Other speakers include Bostic (Atlanta, Monday), Evans (Chicago, Monday), Barkin (Richmond, Tuesday), Mester (Cleveland, Thursday), and Harker (Philadelphia, Thursday).
|Wednesday||CPI, Mar., MoM||1.2%||0.8%|
|Wednesday||Core CPI, Mar., MoM||0.5%||0.5%|
|Thursday||PPI Final Demand, Mar., MoM||1.1%||0.8%|
|Thursday||PPI Core Final Demand, Mar., MoM||0.5%||0.2%|
|Thursday||Retail Sales Ex Auto, Mar., MoM||-0.1%||-1.2%|
|Thursday||Retail Sales Control Group, Mar., MoM||0.5%||1.3%|
|Thursday||Univ. Of Mich. Sentiment, Apr. P||58.6||59.4|
|Thursday||Univ. Of Mich. 5-10Y Inflation Exp., Apr. P||3.0%|
|Thursday||Initial Jobless Claims||175k||166k|
|Thursday||Industrial Production, Mar., Mom||0.4%||0.5%|
|Thursday||Univ. Of Mich. 5-10Y Inflation Exp., Dec. F||3.0%|
Fed Speak and Discussion
We have a good idea where the Fed is heading in the near- to medium- terms. The Fed will likely hike rates by 50bp in each of the May and June meetings and begin quantitative tightening in May. To be sure, few Fed speakers have said they would definitely hike 50bp at the next meeting, but overall, they are leaving plenty of breadcrumbs to lead us to that conclusion. The message is clear: The Fed believes it needs to push rates to neutral as quickly as it can without breaking the economy or markets. That requires a series of more than one 50bp hike. The latter part of the year is of course more uncertain but given the likely path of data our baseline is a third 50bp hike in July before the Fed has the luxury of easing back to 25bp rate hikes.
The briefly lived inversion of the yield curve plus the wider acknowledgement that the Fed is taking inflation seriously continues to feed into recession fears. Via Bloomberg:
Former Treasury Secretary Lawrence Summers predicted that the consensus among economists will increasingly fall in line with the U.S. tipping into a recession next year.
“The combination of overheating, followed by policy delay followed by supply shocks means I think it’s a very difficult set of challenges, and recession in the next couple of years is clearly more likely than not,” Summers told Bloomberg Television’s “Wall Street Week” with David Westin on Friday. “I suspect that’s how the consensus will evolve.”
The latest monthly survey of economists by Bloomberg showed the chance of a recession over the coming 12 months increased to 27.5% from 20% in March. Summers also highlighted that the U.S. has never experienced inflation above 4% and unemployment below 4% without that being followed by an economic slump within two years. Last month, consumer prices are estimated to have surged more than 8%, while the jobless rate was 3.6%.
My baseline expectation is that underlying inflation has risen sufficiently above the Fed’s 2% target that a soft-landing is out of reach, but, as always, timing is the key matter. The Fed isn’t going to rush into the conclusion that it needs to risk a recession, and it seems far too early in this cycle to be thinking about a recession. The steepness at the front end of the yield curve suggests no recession in the next year, while the swiftness with which the inversion at the longer-end of the yield curve reversed suggests we should have little concern that it signaled recession over a longer horizon:
Compared to when interest rates peaked in the last cycle, the economy now is much, much stronger. There is too much momentum to see a recession in the next twelve months, and the yield curve by first flattening and then lifting upward is behaving much as I hoped it would if the economy can withstand higher rates. If the neutral rate has risen, the Fed and financial market participants will need to learn their way to that new neutral rate, and the first step in the process is to start moving rates higher and see what happens.
That said, the speed at which rates are moving will eventually cause some heartburn for the Fed. For now, it is full steam ahead for monetary policy. The Fed wants to push rates to neutral, and even a little beyond, but hopes that enough of the inflation surge will be transitory and that a soft-landing can be achieved with only modestly tight monetary policy. Too rapid of a rise in rates, however, may become disruptive for the economy and raise concerns that the Fed is prematurely courting a recession. There will be a limit to how much tightening the Fed will tolerate being priced into markets in the near term. The trick of course is that we don’t know where the limit is, only that we are closer to it than three months ago.
The sharp rise in mortgage rates will take some time to digest. The housing sector looks poised to get a bit messy here. One issue to watch for is cancellations. Tight supply chains have lengthened out the time to completion for housing. Buyers who signed a contract to build six months ago still don’t have a house, and now find themselves unable to afford that house given the rise in mortgage rates. This should trigger cancellations, which will intensify the growing challenges in the home building sector. The combination of higher mortgage rates reducing pricing power plus still high production costs may induce builders to scale back new supply which shows up in the permits and starts data. It’s easy to see how this kind of dynamic will lead to crosscurrents in the data. Other issues might emerge. We don’t know in real time if incomes are growing quickly enough to compensate for higher rates. We don’t know how many people are panicking to buy because they locked in lower rates last month. We don’t know how much inventory will come on the market from owners looking to sell at the peak. And we don’t know how much inventory will be pulled off because existing owners don’t want to let go of their 3% mortgage rate to trade up.
If we get enough crosscurrents in the data and some easing of inflationary concerns as we enter the back half of the year, the Fed will amplify the idea of pausing after it reaches something close to neutral. I don’t think this is imminent and am happy to ride the hawkish train as long as it lasts. I can tell a story that overheating labor markets feed into higher inflation expectations such that not only is the neutral rate higher, but the Fed also needs to push rates well above neutral. That’s how we get to terminal rates north of 4% as I see some commentators are now speculating. At the same time, eventually higher interest rates will bite somewhere in the economy, and I am very much aware of the growing recession/peak inflation narrative that will intensify if crosscurrents emerge in the data. These two stories are not mutually exclusive; the crosscurrents/pause story might just be a stopping point along the way to the 4+% outcome. But those stories are out there and need to be on our radar. The bad place the Fed is hoping to avoid is crosscurrents in the data plus no easing of inflationary pressure. That’s where it would become apparent that inflation isn’t dissipating without a sharply restrictive monetary policy.
My broader point is that I am watching for an inflection point in the next few months. We have gone a long way in a short amount of time. Is there further to go? I think so, yes, but the path may not be as straight as it has been.
Good luck and stay safe this week!