Monday Morning Notes, 8/1/22
If You Don’t Have Time This Morning
Inflation is running hot, and the Fed is super-hawkish, but the Fed hasn’t been able to make that message stick in this market. The Fed hasn’t been calibrating its message to market conditions, and it might take some hard guidance on the next rate hike before the Fed can effectively sell its story.
Recent Data and Events
The economy shrank for a second consecutive quarter with GDP clocking in at a -0.9% rate in 2Q22. While this was not a strong report by any measure, as you know I am skeptical that we should define this as a recession beginning at the start of the year. Beyond the substantial and non-recessionary job growth in the first of the year, the divergence between gross domestic product and gross domestic income suggests that GDP overstates economic weakness:
Similarly, while GDP growth is tracking lower than the level indicated by the weekly economic index, GDI is tracking in line with this measure:
I think GDP will firm in the third quarter (the Atlanta Fed measure is at an admittedly early 2%), but we will have to wait to see. Meanwhile, the weak GDP report only reinforced the recession narrative that has market participants looking forward to the Fed cutting rates in the first quarter of next year. While the Fed is watching for signs of slower growth as reason to moderate the pace of rate hikes, note also that nominal GDP grew at a whopping 7.8% pace in the second quarter. I think the Fed remains more worried about inflation than it may appear from Federal Reserve Chair Jerome Powell’s performance at last week’s presser would lead one to believe. More on that later.
Personal spending rose a solid 1.1% in nominal terms, but inflation eroded the gains such that real spending only grew 0.1%:
The strength in nominal spending is somewhat surprising given personal income grew “only” 0.6% and wage and salary growth has slowed noticeably:
Slower income growth, if sustained, should slow nominal spending capacity over time and put downward pressure on inflation. That said, we warned that this process may be offset if households tap the unexpected increase in wealth that accrued during the pandemic to support spending, and this is exactly what is happening. The savings rate fell from 5.5% in May to 5.1% in June, a new cycle low, leading to another drop in excess savings:
It still has a long way to fall and suggests the Fed may need substantial weaker job growth than it expects is required to stem nominal demand.
Core PCE inflation accelerated to a 7.4% annualized pace:
The long view:
The Dallas Fed trimmed mean inflation rate also popped higher, indicating wider inflation pressures:
This rebound is exactly why the Fed claims it needs compelling evidence that inflation is on a downward trajectory before it can stop rate hikes let alone cut rates. The experience of the past year is that periods of lower inflation prove to be ephemeral. If the Fed wants to be sure it will restore price stability, it expects it will need multiple months of good inflation numbers before it can cut, which seems improbable before later in 2023. Still, market participants interpreted Powell’s press conference as indicating a low pain point on growth and unemployment, with the implication that the Fed will cave and cut rates before sufficient inflation data amasses to prove that the Fed has clearly achieved a path to price stability. Market expectations are reasonable given the Fed’s past behavior, and the Fed cannot prove its resolve until it hikes into measurably higher unemployment.
The ECI number came in a bit hotter than expected, with the headline rising 1.3% rather than the 1.2% Wall Street was looking for:
Excluding incentive-based employees, private sector wage and salary growth remains well above the pre-pandemic pace:
Powell has suggested this measure is a key gauge of the health of the labor market, and this number will do nothing to ease his concern that labor demand is still too high. At best, it suggests peak labor market pressure. I am skeptical, however, that ECI growth falls enough to put downward pressure on underlying inflation without a recession.
New home sales fell again in June:
The degree of decline, however, is arguably modest given that mortgage rates spiked in June, which speaks to the underlying demographic demand for housing. With mortgage rates down since June and buyers and sellers adjusting to the new reality of higher rates, we may soon see a bottom in housing activity.
Initial unemployment claims edged down:
The non-seasonally adjusted series fell in line with past years:
I take this as further evidence that a distortion of seasonal adjustment factors due to the pandemic drove the decline in claims earlier this year. In other words, claims have not risen as much as it first appears, although that doesn’t mean they won’t move higher in the months ahead. Note also that although the peak in claims occurred one week later than in 2016-2019, a reader pointed out the this was the same week claims peaked in 2012-2015, meaning the timing of the peak this year is not unusual.
Upcoming Data and Events
It’s jobs week. We get the usual PMI reports this week, manufacturing on Monday and services on Wednesday. The JOLTS report arrives on Tuesday, and it will be closely watched for any signs of falling job openings. I think job openings have a long way to fall before they provide relief, and the Indeed data suggests they are not dropping very quickly:
Still, if market participants continue to focus on the “slow growth, Fed will cut” story, any decline in openings will be met enthusiastically. The same logic holds for Friday’s release of the July employment data. Wall Street already expects an arguably “dovish” decline in job growth to 250k, and a smaller number or an uptick in the unemployment rate will help push inflation concerns further into the background.
Fed speak is light this week, watch for the possibility that some Board members add interviews to their schedule to push back on market pricing. On Tuesday, Chicago Federal Reserve President Charles Evans hosts a breakfast conversation with journalists. Also on Tuesday, St. Louis Federal Reserve President James Bullard will provide an economic and policy outlook. Before the FOMC meeting, Bullard said the June CPI report suggested the Fed should push rates to 3.75-4% by the end of the year, which is the equivalent of three more 50bp hikes, and I expect he will reiterate that message. On Thursday, Cleveland Federal Reserve President Loretta Mester will talk about the economy and policy. Mester has been a reliable standard-bearer for the Fed in recent months, and I expect her to push back on the market’s dovish interpretation of the FOMC meeting.
|Monday||S&P Global US Manufacturing PMI, Jul. F||52.4||52.3|
|Monday||ISM Manufacturing, Jul.||52.1||53.0|
|Tuesday||JOLTS Job Openings, Jun||11.0m||11.3m|
|Wednesday||S&P Global US Services PMI, Jul. F||51.6||51.6|
|Wednesday||ISM Services, Jul.||53.5||55.3|
|Wednesday||MBA Mortgage Applications, Jul. 29||—||-1.8%|
|Thursday||Initial Unemployment Claims||255k||256k|
|Friday||Unemployment Rate, Jul.||3.6%||3.6%|
|Friday||Nonfarm Payrolls, Jul.||250k||372k|
|Friday||Average Hourly Earnings, MoM, Jul.||0.3%||0.3%|
Fed Speak and Discussion
The Federal Reserve remains on track for continued rate hikes. The first post-FOMC comments came from Atlanta Federal Reserve President Raphael Bostic, who thinks that the economy is not in recession and the Fed has more work to do, albeit he is uncertain how much more. Via the Wall Street Journal:
“I’m convinced we’re going to have to do more in terms of interest-rate moves, but exactly how much and then what trajectory will depend on how the economy evolves over the next several weeks and months,” Mr. Bostic said. “We’re going to get a lot of data in the next two months before our next meeting and that will give us a good indication of what the right course of action is likely to be.”
Of course, Bostic is being coy about the size of future rate hikes, and we expect others will too, at least for a few weeks longer. Sooner or later though, after journalists ask “50 or 75” enough, they will get an answer. Still, the way markets are moving, the Fed may have little choice but to firm up guidance sooner than expected.
Our baseline case is that the Fed steps down to a 50bp hike in September, but the risk is very much weighted toward another 75bp. The latest readings on inflation and employment argue in favor of 75bp, but we see two more months of data between now and the September meeting, which provides plenty of possibilities to cut either way.
Still, the Cleveland Fed expects July core CPI and PCE to come in at 0.48% and 0.39%, respectively. Those are big numbers, meaning that either August inflation needs to come down sharply or the Fed needs to lean on the growth slowdown/already at neutral policy story to justify 50bp. Powell’s performance at the press conference suggests the Fed is looking heavily at the latter story which is why I see it as the baseline. The Fed appears to be looking for a less expeditious path to moderately restrictive policy than the very expeditious path to neutral.
Indeed, leaning on the growth outlook may be the only way to justify 75bp in September if the Fed needs to raise the 2022 inflation forecast. After Friday’s PCE report, core-inflation looks on track to settle at 4.5% this year, compared to the Fed’s current forecast of 4.3%. That assumes 0.4% in July and 0.3% thereafter. If you assume the rest of the year is the average of the first half of 2022, 0.41%, the q4/q4 rate of core inflation will be 5%.
Interestingly, former Federal Reserve Vice Chair for Supervision Randall Quarles took on a dovish tone Friday:
“It is not surprising that you would see a strong move by the Fed and still see inflation coming in a little ahead of expectations immediately afterwards, because the effect of this move isn’t going to be felt for a number of months,” he said. “Demand-driven inflation is exactly what the Fed can control, and the interest-rate moves that they are making are exactly what will bring it under control, and I think we’ll see the effectiveness of that policy relatively soon.”
Typically, I don’t say much about the views of former Fed officials, but after last week’s press conference I admit I am wary that the Fed may start adopting similar language on inflation, basically a reversion to a peak inflation, forward looking story. Indeed, some of that is already certainly happening. Consider this from Powell:
But we’ll be asking, do we see inflationary pressures declining? Do we see actual readings of inflation coming down? So, in light of all that data, the question we’ll be asking is whether the stance of policy we have is sufficiently restrictive to bring inflation back down to our 2 percent target. And it’s also worth noting that these rate hikes have been large and they’ve come — they’ve come quickly, and it’s likely that their full effect has not been felt by the economy.
So there’s probably some additional tightening, significant additional tightening in the pipeline.
Like his discussion of slowing growth, I don’t think this is an effort to be dovish, but to create a path to stepping down from 75bp, basically saying that continued 75bp hikes become reckless at some point. Still, that’s the kind of language market participants will grab a hold of. If Fed speakers start embracing that forward looking language, and especially if they elevate it above the incoming inflation numbers, as Quarles did, they will only reinforce the notion that market participants can safely focus on the upcoming rate cuts.
Similarly dovish was Powell’s assuredness that policy rates were now at neutral after last week’s hike. Former U.S. Treasury Secretary Larry Summers was taken aback:
“Jay Powell said things that, to be blunt, were analytically indefensible,” Summers said on Bloomberg Television’s “Wall Street Week” with David Westin. “There is no conceivable way that a 2.5% interest rate, in an economy inflating like this, is anywhere near neutral.”
Again, I ‘think’ that Powell is using this neutral language primarily as a mechanism to back down from 75bp hikes at future meetings. “Neutral” is in some way just the potential inflection point, but rates will continue to rise. That said, I do think this language is counterproductive in that it helps set a ceiling on rates. It’s hard to justify 10-year rates too much above 3 to 3.5% when the entity that sets the path of rates signals that the path of short-term rates will settle back to 2.5% in the not-so-distant future. I get the sense that a not-insignificantly sized group of market participants very much want to take long rates to 4% or higher, and they are very frustrated that this hasn’t happened, and they want Powell to say something that makes it happen, but I am not sure that it can happen when the Fed effectively communicates that the financial system should be structured around an average 2.5% short-term rate. I remain curious to see where rates would settle out if the Fed stopped giving estimates of neutral.
Importantly, we need to be careful not to dismiss Powell’s hawkish moments. Powell repeatedly leaned into the June SEP, which I interpret as directly pushing back on market pricing. The June SEP is a “higher for longer” rates story. Moreover, he repeatedly emphasized that inflation was an overarching concern. There were frequent moments like this:
QUESTION: The question was whether you see a recession coming, and how that might or might not change policy.
JEROME POWELL: So we’re going to be — again, we’re going to be focused on getting inflation back down and we — as I’ve said on other occasions. Price stability is really the bedrock of the economy, and nothing works in the economy without price stability. We can’t have a strong labor market without price stability for an extended period of time.
Still, even on the inflation front there was a sense that Powell was a less committed to price stability than we saw at Sintra. Consider this, from just a few weeks ago:
“The clock is kind of running on how long will you remain in a low-inflation regime … The risk is that because of the multiplicity of shocks you start to transition into a higher inflation regime, and our job is to literally prevent that from happening and we will prevent that from happening,” Powell said at a European Central Bank conference.
The “clock is ticking” is strong language. And at the same conference, Cleveland Federal Reserve President Loretta Mester made clear the risk to the inflation mandate was the primary concern:
In the current situation, from a risk-management perspective, it is important for policymakers to ask which situation would be more costly: erroneously assuming longer-term inflation expectations are well anchored at the level consistent with price stability when, in fact, they are not? Or erroneously assuming that they are moving with economic conditions when they are actually anchored? Simulations of the Board’s FRB/US model suggest that the more costly error is assuming inflation expectations are anchored when they are not. If inflation expectations are drifting up and policymakers treat them as stable, policy will be set too loose. Inflation would then move up and this would be reinforced by increasing inflation expectations. If, on the other hand, inflation expectations are actually stable and policymakers view the drift up with concern, policy will initially be set tighter than it should. Inflation would move down, perhaps even below target, but not for long, since inflation expectations are anchored at the goal.
But last week, Powell suggested the risks were more balanced:
We’re trying not to make a mistake. Let me put it this way; we do see that there are two-sided risks. There would be the risk of doing too much and, you know, imposing more of a downturn on the economy than — than was necessary. But the risk, the risk of doing too little and leaving the economy with this entrenched inflation, it only raises the cost.
This doesn’t feel quite as committed to price stability, and the change in tone since Sintra is eating at me. It certainly makes no sense given the inflation data, which leaves open the possibility that the Fed has suddenly become nervous about all the recession talk despite asserting that there is no recession underway. And that leaves me just a little more concerned that they won’t see this through, that like in the 1970s there won’t be support for restoring price stability once unemployment moves higher.
The collapse of real yields illustrates the market’s takeaway from last week’s presser. Real yields are headed back to negative territory:
This kind of move will support risk assets and housing. I don’t think this was the Fed’s intention, but it is the natural consequence of the delivery of the Fed’s post-FOMC message (although I am hearing that market positioning did not do the Fed any favors). The Fed is helping to make it safe to look at your 401k statement again; we will see how long that lasts.
At the end of Friday, Minneapolis Federal Reserve President Neel Kashkari came out swinging against the market’s dovish take on the FOMC outcome. Via the New York Times:
“I’m surprised by markets’ interpretation,” Mr. Kashkari said in an interview. “The committee is united in our determination to get inflation back down to 2 percent, and I think we’re going to continue to do what we need to do until we are convinced that inflation is well on its way back down to 2 percent — and we are a long way away from that.”
“I don’t know what the bond market is looking at in reaching that conclusion,” Mr. Kashkari said, adding that the bar would be “very, very high” to lower rates.
Mr. Kashkari said that it was too soon to know how big of a rate increase might be appropriate in September, but that raising rates by half a point at coming Fed meetings “seems reasonable” to him. He noted, however, that inflation data had been surprising “in a bad way” and that continued higher core inflation could push him to think a three-quarter-point move would be needed
“How much are we going to have to do to break the cycle of inflation and get inflation well on its way back down?” Mr. Kashkari said. “Nobody knows that.” But, he added, “We know we have a job to do, and we’re committed to doing it.”
I don’t understand the surprise, this is exactly what they should have expected. I know many think the Fed doesn’t have a good feel for markets, and these comments speak to that.
Kashkari’s explanation is essentially my understanding of the state of monetary policy (super-hawkish), and the pushback I expect to see from Fed speakers. I think the Fed believes it was leaning into a hawkish story last week. But I don’t know if Kashkari can sell this message. It might have to come from the Board, and maybe only Powell can make it stick. If the Fed wants to sell a hawkish story, it needs to really sell it without caveats. Market participants are looking for Powell to say, “we are going to achieve price stability at all costs” and say that one thing repeatedly until price stability has been achieved. And that’s what market participants didn’t hear last week. Literally, that needs to be the first sentence in response to every question. It needs to be like this:
REPORTER: Why do you like purple ties?
POWELL: We are going to achieve price stability at all costs.
The inflation story can never be perceived as an afterthought until there is compelling evidence that price stability can be achieved. If the Fed wants a hawkish message to stick, it needs to be like a “strong dollar is in our national interest” kind of story.
We always expected communication challenges around stepping down from 75bp. I think that much of the Fedspeak perceived as dovish reflects those challenges. The Fed is super-hawkish, but we went into last week saying that market participants would see any story around slowing growth as dovish even if couched in the hawkish story of rates continuing to rise until the Fed sees compelling evidence of a path to price stability. So far, that’s how this is playing out. Despite my caveats above, I still think the Fed is more hawkish than it appears, and more hawkish than implied by market pricing, and this creates the potential for a clash with the markets if the Fed stays resolute and inflation remains elevated as I expect.
That said, in the near term, market participants may continue to focus on the slow growth story until either they see evidence the economy is firming in Q3, something which if true is likely to take couple of months to emerge in the data, or the Fed starts walking back Powell’s performance and pushes the inflation story hard. I don’t think the Fed wants markets to take on a risk-on posture, and if so, we will see more pushback soon. Mester is the voice on the schedule this week that might make it stick. Still, I wonder if we will need to see this message come from the Board, and specifically from Powell. But this might now be an “actions speak louder than words” situation. I am thinking we should be wary about the Fed ditching this “no guidance” story and locking in 75bp for September. The risk certainly falls on that side of 50bp; even if the Fed is looking for an off-ramp to 50bp, it may have already lost the opportunity.