Monday Morning Notes, 5/16/22
If You Don’t Have Time This Morning
The Fed remains committed to restoring price stability and has signaled another two 50bp rate hikes are needed to help meet that goal. More rate hikes will follow, but the data may allow the Fed to pivot back to 25bp perhaps as early as September. Still, while financial conditions have tightened ahead of the Fed’s actual policy implementation, the data supporting a slower pace of rate hikes will reveal itself only with a lag, which argues for the transition to happen after the September meeting. That means still hawkish talk as we wait for data to turn more helpful for the Fed. It’s still too early to tell if the Fed will need to endure a recession to put inflation back on a path to 2%, but the unemployment rate at a minimum can’t fall further and likely needs to rise. The latter generally doesn’t occur to a meaningful extent outside of a recession.
Recent Data and Events
As I discussed last week, the CPI inflation number came in above expectations and was very much not what the Fed wanted to see. That said, the PPI number released the next day revealed lower inflation on items such as medical care services and airline passenger fees than in the CPI report. For those components, the lower PPI numbers feed into PCE inflation calculations rather than the CPI equivalents. This means that contrary to what the initial read on the CPI report suggested, core PCE inflation may come in on the lower side. While the CPI report raised the odds of a 50bp rate hike in September, the PPI report offers the possibility we could be on the verge of a growing wedge between the CPI and PCE inflation. If the latter came in at 0.3% month-over-month for April, it would remain elevated relative to the Fed’s target, but that rate for the rest of the year would put 2022 inflation at 4.0% compared to the Fed’s current SEP forecast of 4.1%.
In other words, the stage could be set for the Fed to leave its inflation forecast unchanged in the June SEP and, if there is a path to an occasional 0.2% reading, a reduction in the September SEP forecast. To be sure, I wouldn’t jump all in on this outcome just yet but it needs to be on the radar. Here is how Cleveland Federal Reserve President Loretta Mester sums up the inflation picture:
…as we recalibrate our policy, I will be looking for compelling evidence that inflation is on a downward trajectory toward our 2 percent goal. We will be able to gauge improvement by looking at the monthly changes in inflation readings to see if inflation is beginning to move down. The monthly increase in the core PCE price index in March was little changed from its February reading, and the monthly reading of the Cleveland Fed’s median PCE inflation moved down in March. These are positive signs, but in April, monthly CPI inflation increased, and risks to inflation remain strongly on the upside, especially in the midst of the continuing war in Ukraine and the potential that the zero-COVID policy in China will further disrupt supply chains. I will need to see several months of sustained downward monthly readings of inflation before I conclude that inflation has peaked.
The risks to the inflation forecast outlook remain on the upside, but with the tightening in financial markets and its eventual impact on growth, the risks will likely shift back toward more balance later this year.
On the other hand, wage growth remains elevated. Although the wage growth slowed in the April employment report, the Atlanta Fed number remained above the levels of the late-1990s:
This pace of wage growth simply is not consistent with the Fed’s inflation target and needs to come down for the Fed to meet its goal of maintaining price stability. Historically, wage growth does not slow sustainably absent a recession, and as I wrote last week Fed officials increasingly suspect that rebalancing the labor market and controlling wage growth requires higher unemployment rates. Typically, higher unemployment rates occur during recessions, which explains why the Fed has turned increasingly more cautious with respect to the outlook. Federal Reserve Chair Jerome Powell on the problem facing the Fed:
So a soft landing is, is really just getting back to 2% inflation while keeping the labor market strong. And it’s quite challenging to accomplish that right now, for a couple of reasons. One is just that unemployment is very, very low, the labor market’s extremely tight, and inflation is very high. So it will be challenging, it won’t be easy. No one here thinks that it will be easy.
Arguably, keeping the labor market strong does not mean unemployment stays at the current level, but pushing it higher without a recession is the trick. Still, even if the labor market remains hot, if inflation starts to come off the boil, the Fed will have an opportunity to pull back on the pace of rate hikes. A still hot labor market means the Fed can’t pause in the cycle, but more inflation stability means the Fed can at least try to ease pressure on the labor market without flirting with a hard landing. This is the needle the Fed is trying to thread.
Michigan consumer sentiment unexpectedly sank to a new cycle low in May:
Recent numbers have been consistent with those typically experienced during a recession, but the economy is not in a recession. Nor does weak consumer sentiment appear to be dramatically impacting nominal consumer spending. For example, the NY Fed survey of spending expectations continued to rise in April:
We get another read on consumer spending with the retail sales report this week. The University of Michigan reports that inflation continues to drive the ongoing dismal sentiment numbers, not surprising given that inflation forces households to step up the pace of nominal spending just to keep up in real terms. Still, in a welcome development for the Fed, longer-term inflation expectations in the report remain pegged at 3%. A little elevated, but not so much that the Fed will seriously consider hard stopping the economy.
Upcoming Data and Events
Some interesting data in the week ahead. Tuesday, we get the retail sales data for April, and Wall Street expects a solid 0.6% gain on the control group number. An uptick in vehicle sales likely drove the headline number to 1.0%. Despite the weakness on the sentiment number, strong job and wage growth and credit card usage continue to support nominal consumer spending. Also Tuesday is the industrial production report for April. Beyond that, the carefully watched housing data begins to roll in starting Wednesday. Housing is an interest rate sensitive sector of the economy, and rising mortgage rates will eventually bite. Still, the data will likely lag; housing permits, starts, and existing home sale are anticipated to have fallen only modestly in April. A transition toward ARM financing has likely helped mitigate the initial rate shock, but eventually that shock should at a minimum temper home price appreciation.
A manageable amount of Fedspeak this week, although much of it falls on Tuesday, including an appearance by the Chair. Speakers include Williams (New York, Monday), Bullard (St. Louis, Tuesday). Harker (Philadelphia, Tuesday and Wednesday), Mester (Cleveland, Tuesday), and Evans (Chicago, Tuesday). The Wall Street Journal will interview Powell live on Tuesday. I expect he will stick with his recent hawkish messaging and focus on assuring the public that the Fed intends to bring inflation under control.
|Tuesday||Retail Sales ex Auto, Apr., MoM||0.3%||1.1%|
|Tuesday||Retail Sales Control Group, Apr., MoM.||0.6%||-0.1%|
|Tuesday||Industrial Production, Apr., MoM||0.4%||0.9%|
|Wednesday||MBA Mortgage Applications, May 13||—||2.0%|
|Wednesday||Building Permits, Apr.||1825k||1873k|
|Wednesday||Housing Starts, Apr.||1770k||1793k|
|Thursday||Initial Jobless Claims||200k||203k|
|Thursday||Existing Home Sales, Apr.||5.66m||5.77m|
Fed Speak and Discussion
Best to begin with the obvious. The Fed is committed to restoring price stability. To meet that commitment, the Fed expects it is just at the beginning of a series of rate hikes, including 50bp hikes at the next two meetings. The Fed needs to follow through on its general path to maintain the amount of tightening that has already occurred in financial markets. The situation beyond that is fuzzy with market participants now pricing in a roughly 50% chance of another 50bp hike in September (we have been warning that September is a potential pivot point for policy) and a terminal rate of 3.0-3.25% in 2023. With inflation elevated and unemployment low, there is no conflict between the Fed’s mandate. This makes it easy for the Fed to stick to a hawkish narrative.
Larger rate hikes are not likely. As we said last week, Fed officials are sensitive to criticism that Federal Reserve Chair Jerome Powell took 75bp off the table at the FOMC meeting press conference and so have left the option open with caveats. Powell himself walked back that perception in his interview with Marketplace:
I said we weren’t actively considering that. But I said what we were actively considering, and this is just a factual recitation of what happened at the meeting, was a 50-basis point increase, that’s a half a percentage point increase, the first one in more than 20 years. And that we thought that if the economy performs about as expected, that it would be appropriate for there to be additional 50-basis point increases at the next two meetings, so. But I would just say, we have a series of expectations about the economy. If things come in better than we expect, then we’re prepared to do less. If they come in worse than when we expect, then we’re prepared to do more.
The 75-basis point discussion is becoming pedantic. Meetings aren’t decided in advance, but Powell provided very clear directionality that in the most likely states of the world, the baseline is 50bp at the next two meetings. There are other states of the world, however, where the Fed needs to adjust course – just as the Ukraine war took 50bp off the table at the March FOMC meeting. That brings up an important and overlooked point. Interestingly, while markets focus on the question of a 75bp move, few focus on the other side of the story. What could make the Fed pivot back to 25bp in one of the next two meetings? Realistically, the data isn’t going to give the Fed cause to deviate to the downside from its current near-term plan. Something else would need to happen, like when the Ukraine war derailed any momentum for a 50bp hike at the March meeting. A market accident of some sort would be the most likely trigger.
The Fed remains comfortable with the direction financial markets have taken. The Fed intends for its policy path to tighten financial conditions; that’s the path to slower demand and, hopefully, restoring price stability. Indeed, San Francisco Federal Reserve President Mary Daly told Bloomberg she wants even tighter financial conditions on Wall Street:
“I expect financial conditions to tighten even more as we march through these rate increase and remove stimulus from the economy,” Daly said. “I think we’ve made a good start on them already, but I would like to see continued tightening of financial conditions — that would be consistent with bringing supply and demand back into balance.”
While there is such a thing as overplaying your hand, financial conditions yet do not appear to be too tight. If we use the popular Goldman Sachs FCI, conditions are simply back to pre-pandemic levels:
To be sure conditions are still not as tight as the winter of 2018/19, but should that really be the goal? That episode ventured into the territory of disorderly and disruptive. Right now, it is beginning to feel like something of a sweet spot for the Fed where conditions have tightened enough to offer a path to trimming the demand side of the economy but not so much as to force a shift in the Fed’s rhetoric. That doesn’t mean the Fed won’t eventually need to bring rates even higher than current expectations, but it can potentially move more gradually later this year.
For now, it’s a waiting game for the Fed. Barring a market accident, the Fed is looking for clear and convincing evidence of a path to price stability to back down from 50bp rate hikes. The magnitude and speed of financial tightening will have an impact on growth. Reduced wealth due to lower equity and crypto prices, layoffs in tech as firms scale back and venture capital money dries up, higher interest rates on consumer lending, a stronger dollar, and slower global growth will weigh on spending, job growth, and, ultimately, consumer prices. But this will take some time. To be sure, the near-term data will be solid, it’s baked in the cake at this point. But we need to be looking toward the future; tightening cycles always have economic impact. Moreover, while strong, the economy is slowing:
I have been flagging the evolving outlook in the past couple of weeks, and arguably markets are starting to sniff out some change in the air. Bonds yields have run into resistance on the upside, stocks and bonds regained their traditional relationship last week, and TIPS inflation break-evens are off their highs.
This is a space where the data may be shifting but Fed officials remain committed to the current hawkish script. This space is typically uncomfortable as it often appears that Fed officials are oblivious to incoming information. I am more focused on what the Fed will be saying in September than what it is saying now. Cleveland Federal Reserve President Loretta Mester (who I think is the most underrated Fed president) is among those who have the September meeting in mind asa possible pivot point:
…So given economic conditions, ongoing increases in the fed funds rate are called for, and unless there are some big surprises, I expect it to be appropriate to raise the policy rate another 50 basis points at each of our next two meetings…
…Broader financial conditions have already tightened considerably, as markets have anticipated further rate increases in light of the Fed’s forward guidance…If by the September FOMC meeting, the monthly readings on inflation provide compelling evidence that inflation is moving down, then the pace of rate increases could slow, but if inflation has failed to moderate, then a faster pace of rate increases may be necessary.
Given the strength of the underlying economy – firms continue to add employees at a rapid pace, for example – the natural lags between policy and outcomes suggests September is still too early for a 25bp rate hike. But September could still be at a pivot point by signaling a 25bp hike at the next meeting. A transition back to a slower path of rate hikes would reduce the odds of a hard landing for the economy. The longer inflation remains persistently elevated, however, the higher also the risk of a hard landing. And as Mester highlights, there is a risk that inflation does not moderate. If so, we think absent a jump in inflation expectations the Fed continues 50bp hikes through the end of the year before it entertains the option of a 75bp hike. I also don’t think the Fed wants to start tossing 75bp rate hikes into down financial markets unless it must. Such a move risks creating a self-defeating market accident.
It’s waiting time. The data flow will eventually slow in response to tighter financial conditions. Eventually the Fed will need to take lags into account when setting policy, but that time is not now. The Fed will be looking at the September meeting as a potentially key juncture in the policy path.
Good luck and stay safe this week!