Tim Duy’s Fed Watch, 5/31/22

Published on May 31, 2022
SGH Insight
Tuesday Morning Notes
If You Don’t Have Time This Morning
We are still waiting for data to provide guidance on the Fed’s path beyond the July FOMC meeting. As a baseline, the Fed will not skip a meeting in September but instead continue hiking through the end of the year. When and if the Fed can transition to 25bp rate hikes is still an open question. The Fed doesn’t want to get too far ahead of the data, and while it waits for the inflation and labor market data still to come before the September meeting, it has a hard time committing to anything more than a return to a “measured” pace of rate hikes in September. Still, the Fed leans hawkishly, and we think the data will most likely push the Fed to continue with another 50bp hike after the July meeting.
Market Validation
Bloomberg 6/2/22

Federal Reserve Vice Chair Lael Brainard said market pricing for 50 bps hikes in June and July seems like a “reasonable” path, and it’s “very hard to see the case for a pause” in Sept.
Brainard speaks in interview on CNBC
If there’s no deceleration in inflation prints, it might well be appropriate to have another meeting where Fed raises rates 50 bps; could also raise by smaller amount
No. 1 challenge is to get inflation down, and Fed will do what’s necessary; she’s looking for a “consistent string of data” showing cooler inflation
Very hard to predict with precision when inflation will come down, but Fed’s tools are starting to have desired effect
“We do expect to see some cooling of a very, very strong economy over time”

Tuesday Morning Notes

If You Don’t Have Time This Morning

We are still waiting for data to provide guidance on the Fed’s path beyond the July FOMC meeting. As a baseline, the Fed will not skip a meeting in September but instead continue hiking through the end of the year. When and if the Fed can transition to 25bp rate hikes is still an open question. The Fed doesn’t want to get too far ahead of the data, and while it waits for the inflation and labor market data still to come before the September meeting, it has a hard time committing to anything more than a return to a “measured” pace of rate hikes in September. Still, the Fed leans hawkishly, and we think the data will most likely push the Fed to continue with another 50bp hike after the July meeting.

Recent Data and Events

As we expected, consumer spending continues to power forward in aggregate despite this year’s inflation surge. Nominal spending rose 0.9%, while real spending grew a solid 0.7%. Real spending on both goods and services rose, with goods spending well off its peak but still above pre-pandemic trend:

Households have been unable to absorb inflation and boost real spending on services without making a tradeoff somewhere, and that somewhere was real goods spending, a shift that left some retailers overstocked as summer approaches. I still think this is more of a micro than macro issue, although overstocking will lead to greater cost control efforts. In aggregate, we see the big picture problem for the Fed:

Nominal spending growth continues to outstrip the pre-pandemic trend, while real spending growth remains constrained by the trend. For any given amount of nominal spending the Fed lets loose, what doesn’t show up in quantities must show up in prices.

Despite the solid spending numbers, consumer sentiment continues to sink. The University of Michigan consumer sentiment measure fell to a fresh cycle low of 58.4 in May, with the ongoing weakness reportedly attributable to persistently high inflation. Long term inflation expectations held steady at 3%. While consumers are reacting negatively to inflation, they continue to spend, and that continued spending has resulted in some failed or very premature recession predictions based on the weak sentiment numbers. I think betting against the consumer is generally a bad idea. A recession and the subsequent decline in job growth is the primary threat to spending, and as a general rule the causality doesn’t work the other way. Consumer spending doesn’t cause a recession, a recession causes a drop in spending.

Inflation would have taken a bigger bite out of growth in March and April if not for the strong position of household balance sheets. Households compensated for high inflation by reducing the saving rate below pre-pandemic levels:

In effect, households drew down on the excess savings accumulated during the recession, yet plenty of savings remain. Households have barely scratched the surface of the available reserves:

Inflation would be more of a self-limiting process in the absence of the resources available to households to absorb higher prices. That said, the Fed may see some relief going forward on the labor side of the story. Wage and salary growth in aggregate revealed some moderation in April:

The annualized and three-month values are still too high to expect inflationary pressures to moderate, but the trend of the last two months is a little softer. It should continue to decelerate this year if the Fed can moderate the pace of labor market activity, but it is too early to say there is any “clear and compelling” evidence of that occurring. Moreover, as seen with the drop in the savings rate in recent months, households can support spending even if wage growth falters. Still, I maintain my long-time position that aggregate wage and salary growth is a primary force of nominal spending power, and it must moderate to something closer to the pre-pandemic growth rate of 5% to bring inflation back to the Fed’s target.

For the Fed, inflation remains too high but there are tentative signs that maybe it can finally hold its 2022 inflation forecast steady this year. Less helpful for the Fed is that services inflation remains elevated and will offset some of the benefit of easing goods inflation associated with retailers unwinding some excess inventory:

More helpful is that monthly core PCE inflation was lower than core-CPI inflation, as expected, 0.34% compared to 0.57%. Over the past three months, core-PCE inflation is running at a 4% annualized pace:

With this data, you can see a path to the Fed holding its 2022 inflation forecast steady in the June and September SEPs, which could possibly help the Fed justify a transition to 25bp rate hikes at the September meeting. The sharp decrease in trimmed PCE inflation, indicating a narrowing of inflation pressures, also points in this direction:

Still, inflation has been picking up slightly over the past three months:

This means there is also a path for the Fed to still boost its inflation forecast for the year, especially if we are still getting pass-through on the services side of the ledger. See below for more on inflation and what it means for the Fed.

New home sales plunged in April:

Although the decline was steeper than expected, the direction is not a surprise. As we have warned, the economy needs to adjust to tighter financial conditions, including higher mortgage rates. The sharp rise in mortgage rates was certain to reduce demand from marginal buyers, which favors sales at higher price ranges. This exacerbates the ongoing trend toward more expensive housing and helped the average price of new homes sold soar in April:

The housing market needs to adjust to the sticker shock associated with higher mortgage rates, which will be easier now that those rates are coming off the peak. Some of that adjustment will occur via reduced price appreciation. That said, I don’t expect housing to enter a free fall. The underlying demographic support for housing is too strong to expect that outcome.

Upcoming Data and Events

Busy holiday-shortened week ahead. We get key data this week, particularly the JOLTS report on Wednesday and the employment report on Friday. The Fed aims to bring job openings lower, making that the metric to watch in the April JOLTS report. I don’t expect a rapid decline, and there is a long way to go to balance out the labor market, so I don’t anticipate meaningful improvement for the Fed would occur until later this year. Obviously, however, a sustained downward drift in openings would raise hopes at the Fed that inflationary pressures will eventually ease. Similarly, the Fed will be watching the May employment report to see if there is any indication the labor market is cooling. Optimally, the Fed really doesn’t want unemployment to continue falling; if it looks to be heading close to 3% by September, it will be hard for the Fed to shift back to 25bp hikes. Also watch the wage growth numbers as they need to decelerate further to become consistent with 2% inflation.

Plenty of Fedspeak this week, but not an overwhelming amount. Bullard (St. Louis, Wednesday) and Mester (Cleveland, Thursday) both provide economic and policy outlooks, Williams (New York, Wednesday) and Lorrie Logan (soon-to-be Dallas, Thursday) both provide remarks at the Monetary Policy Implementation and Digital Innovation event hosted by the New York Fed and Columbia University. On Friday Vice Chair Lael Brainard will speak on the Community Reinvestment Act. Finally, on Wednesday the Fed releases the latest Beige Book.

DayReleaseWall StreetPrevious
WednesdayS&P Global US Manufacturing PMI, May F57.557.5
WednesdayISM Manufacturing, May54.555.4
WednesdayJOLTS Job Openings, Apr.11.4m11.5m
WednesdayMBA Mortgage Applications, May 27-1.2%
ThursdayADP Employment, May295k247k
ThursdayInitial Unemployment Claims210k210k
FridayUnemployment Rate, May3.5%3.6%
FridayNonfarm Payrolls, May329k428k
FridayAverage Hourly Earnings, MoM, May0.4%0.3%
FridayS&P Global US Services PMI, May F53.553.5
FridayISM Services, May56.457.1

Fed Speak and Discussion

The Fed will hike rates 50bp at each of the next two meetings and September is still up in the air, but we lean toward another 50bp hike. While policy decisions technically happen on a meeting-by-meeting basis, Fed speakers have made abundantly clear their intentions for June and July. The policy debate has moved onto the September meeting, with policymakers such as Chicago Federal Reserve President Charles Evans and Philadelphia Federal Reserve President Patrick Harker indicating their baseline expectation is a transition back to 25bp rate hikes at that meeting. We remain skeptical that the data will cut in that direction by the time of the September meeting, but if by September it looks like the Fed will at a minimum not need to raise the SEP inflation forecasts and can even cut the forecasts, the unemployment rate levels off near current levels, and signs emerge of diminishing labor market overheating, there is space to transition back to 25bp. There are a lot of moving pieces here.

Federal Reserve Governor Christopher Waller leaned hawkishly in a speech Monday and emphasized the importance of the data in future policy decisions:

I support tightening policy by another 50 basis points for several meetings. In particular, I am not taking 50 basis-point hikes off the table until I see inflation coming down closer to our 2 percent target. And, by the end of this year, I support having the policy rate at a level above neutral so that it is reducing demand for products and labor, bringing it more in line with supply and thus helping rein in inflation. This is my projection today, given where we stand and how I expect the economy to evolve. Of course, my future decisions will depend on incoming data. In the next couple of weeks, for example, the May employment and CPI reports will be released. Those are two key pieces of data I will be watching to get information about the continuing strength of the labor market and about the momentum in price increases. Over a longer period, we will learn more about how monetary policy is affecting demand and how supply constraints are evolving. If the data suggest that inflation is stubbornly high, I am prepared to do more.

Waller’s assessment is consistent with our policy expectations. The Fed is serious about leaning hawkish until it can see a “clear and compelling” path back to 2% inflation. Until that time, the policy consensus will tend to land on 50bp rate hikes. Interestingly, Waller also adds this:

My plan for rate hikes is roughly in line with the expectations of financial markets…federal funds futures are pricing in roughly 50 basis point hikes at the FOMC’s next two meetings and expecting the year-end policy rate to be around 2.65 percent. So, in total, markets expect about 2.5 percentage points of tightening this year. This expectation represents a significant degree of policy tightening, consistent with the FOMC’s commitment to get inflation back under control and, if we need to do more, we will.

Waller’s acceptance of current market pricing suggests that at this juncture he expects to see evidence of a path to 2% inflation by the time of the September meeting (2.5 percentage points of tightening is three 50bp hikes and four 25bp hikes). I am not sure he really expects that. To me, his take on market pricing suggests three things.

  • First, there is no sense that the Fed will skip the September meeting. Atlanta Federal Reserve President Raphael Bostic floated his baseline expectation that the Fed will take a pass at the September meeting. That said, let’s be clear: Bostic is not representative of the current debate.
  • Second, there is an underlying consensus at the Fed that it moves in 25bp increments if inflation is not an imminent concern. This is consistent with the path outlined by Evans and Harker. No one knows what the data will reveal, they can’t see more than two meetings ahead, and absent more knowledge of the data the baseline is that the Fed keeps moving forward at a “measured” rather than “expeditious” pace after July. Again, we are skeptical that the data will allow the transition back to “measured” by September.
  • Third, I suspect the Fed doesn’t want markets to price in many more rate hikes ahead of supportive data. Waller says that he wants to bring rates above neutral at the end of the year but is comfortable with market pricing at the middle range of neutral estimates. This is consistent with our view that the extreme effectiveness of forward guidance has pulled forward at least the first round of financial tightening very quickly, setting the stage for a consolidation of financial conditions as we wait for the data to give us further direction. The Fed doesn’t want to us to pull back on current pricing as it has obtained a minimum desired tightening of financial conditions, but at the same time doesn’t want conditions to tighten so quickly that they break the economy or financial markets. Note that Waller tells us the data that could support more hikes could start coming as early as this week’s employment report. Waller, like his colleagues, made clear that the Fed will not hesitate to take appropriate action if conditions do not point toward lower inflation.

In addition to a policy outlook, Waller provided more intellectual weight behind the Fed’s intention to ease inflationary pressures by reducing excess demand for labor. Specifically, Waller outlines the process by which the Fed reduces overheating in the labor market without a dramatic impact on unemployment:

What does all this suggest about what will happen to the labor market when, as I expect, a tightening of financial conditions and fading fiscal stimulus start to cool labor demand? …The March 2022 observation lies at the top of the curve and is labeled point A. If there is cooling in aggregate demand spurred by monetary policy tightening that tempers labor demand, then vacancies should fall substantially. Suppose they decrease from the current level of 7 percent to 4.6 percent, the rate prevailing in January 2019, when the labor market was still quite strong…The unemployment rate will increase, but only somewhat because labor demand is still strong—just not as strong—and because when the labor market is very tight, as it is now, vacancies generate relatively few hires. Indeed, hires per vacancy are currently at historically low levels. Thus, reducing vacancies from an extremely high level to a lower (but still strong) level has a relatively limited effect on hiring and on unemployment.

Waller is fleshing out the story often told by Federal Reserve Chair Jerome Powell where the Fed can create balance in the economy by taking the heat off the labor market such that job openings drop to something closer in line with labor supply. In theory, this doesn’t have to have a large impact on actual hiring because hiring is already constrained. The idea is that once openings come down, there will be less competition for workers, and wage growth will moderate to something consistent with 2% inflation. I have less faith than the Fed that this can be accomplished without a recession, but that is not an imminent concern and, realistically, this is probably the best hope to avoid a hard landing. Importantly, Waller looks to be filling in the theory to support Powell’s policy objectives, and this reinforces our view of Waller as an increasingly key player at the Fed. Aside from Powell, he may be the one to watch most closely.

Bottom Line: The Fed is pressing forward with rate hikes, and Waller’s speech should help erase speculation that the Fed will not follow through with another two 50bp hikes or skip a hike at the September meeting. The minimum expected path this year is a total of 250bp of rate hikes, with the risks clearly skewed to the upside. How much upside, however, will not be evident until we get more data, suggesting at least a temporary plateau for financial conditions until the economy can absorb the tightening of conditions so far this cycle. That said, we think the data will eventually argue for another leg up in rates later in the year.

Good luck and stay safe this week!

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