Monday Morning Notes, 9/20/21
If You Don’t Have Time This Morning
No tapering at this week’s FOMC meeting but look for signals that point us toward November. I expect the Fed will be hawkish on the 2022 dots and dovish on the 2024 dots. The actual outcome will presumably add to our understanding of how the Fed interprets the new policy framework.
Recent Data and Events
Retail sales came in above expectations although previous months were revised downwards. I don’t get too caught up with the monthly changes; I look for the underlying trends. Overall, core retail sales are trending sideways in recent months while food services sales have returned to the pre-pandemic trend:
The important story is that aggregate spending has been resilient to the Delta wave, matching the Fed’s expectations that subsequent waves of the pandemic will have increasingly smaller demand effects. I still think the main impact of the Delta wave will be via supply chain disruptions from, primarily, overseas.
Industrial production continues to climb higher as firms work to rebuild inventories and meet demand:
Almost all sectors are in expansion:
Still, auto production remains hobbled by a dearth of computer chips:
The ongoing challenges in the auto industry come in the face of continued strong demand aggravated by a need to replace vehicles damaged by Hurricane Ida and subsequent flooding in the Northeast. This is helping keep upward pressure on used-car prices. Via Bloomberg:
Used car prices, one of the biggest drivers of U.S. inflation this year, rose again in early September on a monthly basis after idling over the summer.
The Manheim U.S. Used Vehicle Value Index, a measure of pricing trends, increased 3.6% in the first half of September compared with a month earlier. That puts it on track for the first month-over-month increase since May while extending the string of consecutive monthly of gains on a year-over-year basis that dates back to June 2020.
This will delay the hoped-for declines in used car prices in consumer prices measures. I discussed the latest CPI report in Tim Duy’s Fed Watch 09/15/21.
The University of Michigan Consumer Sentiment headline number for September came in light at 71.0, a touch below expectations. The political divide in the survey leads me to be wary of reading too much into the headline number. The accompanying note identified prices as a source of concern. Near term inflation expectations edged up while longer-term they remained at 2.9%:
I see two stories here. First, the still high near-term expectations numbers suggest that we should be cautious about reading too much into last week’s CPI report. Consumers aren’t sensing a near term change in inflation. That said, the second story is that consumers also still expect the inflationary surge to be largely transitory. To be sure, longer term inflation expectations as measured here began an upward trend last summer but are now only back to levels I think the Fed would believe consistent with its inflation target. I don’t think, however, that the Fed would welcome ongoing increases.
A note of caution on longer-term inflation expectations. I don’t think we should interpret the apparent expected transitory nature of inflation as a signal that the Fed doesn’t need to worry about inflation. Presumably there are expectations about policy between the two. Stable long-term inflation expectations mean that agents think the Fed will take appropriate action to hold inflation near target. That action might be signaling and implementing less accommodative monetary policy.
Upcoming Data and Events
Major data releases are anticipated to reveal the economy remains on its current path. Housing data for August including permits and starts (Tuesday), existing home sales (Wednesday), and new home sales (Friday) are all expected to remain close to August numbers now that the sector has rebalanced away from an unsustainable pace of sales earlier this year. Likewise, Markit PMIs for September are expected to reveal only a very modest softening compared to August. Initial claims are expected to edge lower.
The main event of the week is the FOMC meeting and the subsequent press conference. There will be plenty of opportunities to clear up any misunderstandings that may occur after the press conference. On Friday both Mester (Cleveland) and George (Kansas City) present economic outlooks that presumably will follow the forecasts they contribute to the SEP. On Friday there is also a Fed Listens event with appearances by Powell, Clarida, and Bowman. And on Saturday Williams (New York) will present an academic paper. Lots of clients ask why we don’t hear much from Williams lately; I don’t have an answer.
|Tuesday||Building Permits, Aug.||1600k||1635k|
|Tuesday||Housing Starts, Aug.||1550k||1534k|
|Wednesday||Existing Home Sales, Aug.||5.86m||5.99m|
|Wednesday||FOMC Meeting Concludes||—||—|
|Thursday||Markit US Manufacturing PMI, Sep. P||60.5||61.1|
|Thursday||Markit US Services PMI, Sep. P||55.0||55.1|
|Thursday||Initial Jobless Claims||320k||332k|
|Friday||New Home Sales, Aug.||709k||708k|
Fed Speak and Discussion
This week’s FOMC meeting is turning into something of a nail biter with the dots being the main source of contention. The general expectation is that this next meeting is too early to announce a tapering decision. I concur; the likely outcome of this meeting is guidance that opens the door to tapering at a subsequent meeting. I believe the consensus at the Fed is circling around the November meeting, the meeting most consistent with guidance from the Fed that is will likely be appropriate to taper this year. In contrast, the December meeting occurs in the middle of the month so a decision to taper at that meeting likely results in actual tapering next year, beginning in January 2022. That said, the Fed will not pre-commit to November yet but instead just leave the impression that as long as the economy maintains its current course, tapering is likely to occur that month.
There is general agreement that the dots will drift up, but by how much? The surveys crossing my desk indicate market participants are split roughly 50-50 on the issue of a rate hike appearing in the 2022 dots. The arguments against this outcome tend to focus on the deceleration in growth, the Fed’s emphasis on inflation outcomes as “transitory,” and the challenge of delinking the tapering and rate hike decisions. I think these are well-reasoned points and could win the day.
I expect the dots will reveal the median FOMC participant anticipates a rate hike in 2022. I place 70% odds on this outcome. I think there is excessive focus on the growth slowdown. Downward revisions from a 6.6% second quarter growth rate (which no one expected was sustainable) on the back of primarily supply-side constraints is not the same as slowing from 2% on the back of demand side weakness. In the current situation, there will still be more than enough growth to continue to reduce excess slack in the economy and place downward pressure on unemployment. I expect unemployment forecasts will be largely unchanged near the current 3.8% for 2022, a forecast below the 4% longer rate.
On inflation, the core-PCE inflation forecast for 2021 will be at least 3.7%, a level well above what anyone on the Fed thinks is moderate, and the 2022 forecast, currently 2.1%, will rise to at least 2.2% (I think 2.3% but arguably that is an aggressive call), and 2023 will likely still be above 2% as well. That means the inflation surge is almost entirely transitory (in line with the Fed’s story) but with enough persistence to drive underlying inflation moderately above the Fed’s 2% target. This strikes me as a forecast in which the Fed is likely to achieve its objective of 2% average inflation with expectations of continued above target inflation (certainly the new policy framework is sufficiently undefined and flexible to admit such an outcome is likely) in the context of something close to full employment in 2022 and thus a forecast of a rate hike in 2022 would be appropriate policy. Remember too that the Fed will not view this as slamming on the brakes. In the context of the forecasted period of elevated inflation, a single rate hike is a very dovish policy.
In addition, I think FOMC participants on average will consider firmer inflation expectations as arguing in favor of slightly less accommodative policy stance. The Fed wanted inflation expectations to firm into a range consistent with the 2% target; we are already in that range. In that sense, I think the Fed would be comforted by the relative stability in the University of Michigan long run inflation forecast and unsettled by the continued rise in the New York Fed measure. I think the stories filtering up to the Fed from the business community relate an environment of rolling supply shocks not likely to be resolved until the middle of next year at the earliest, an ongoing labor shortage, rapidly rising wages, increased pressure to push costs onto consumers, and an increased willingness of consumers to accept those costs. In this environment, does the Fed really want to send a signal that they care naught about surging inflation that by their own forecasts is not entirely transitory? A rate hike in 2022 would be only the smallest of signals that it acknowledges the current pricing environment. Again, no one is talking about hyperinflation; the space the Fed is working with is roughly 50bp or less from the 2% target.
Admittedly, there is also a numbers game at play here. Only two dots need to shift off zero to get a partial rate hike in the median, three for a full rate hike. The above logic doesn’t need to be adopted by all eleven participants who in June expected no rate hike in 2022, just three of them.
Also contentious is the question of the 2024 dots. I think the consensus is that the 2023 dots will reveal another two hikes. For 2024, there is an argument that the Fed will signal another four hikes. The logic here – again, entirely reasonable – is that the Fed will be intentionally behind the inflation curve and consequently will need to move policy rates quickly up to neutral to stave off inflationary pressures. Surely this is the thinking of a least a minority of FOMC participants and will be evident in the upper range of the dots. I expect a more dovish reaction function in which the median policy maker anticipates only another two rate hikes in 2024. I think in the context of the new policy framework, the median policy maker will anticipate a more gradual return to the neutral rate, driven both by a desire to not slam the brakes on the economy and the short distance to neutral. Also, pulling the lift off into 2022 could be seen as a risk management exercise that allows for a more dovish path of subsequent rate hikes. That said, I admit to not being entirely confident on the 2024 dots. I think four hikes is too aggressive but the risk to my outlook is that the median policy maker anticipates three hikes in 2024.
Regarding the press conference, I think Federal Reserve Chair Jerome Powell will again try to separate tapering from rate hikes. I think the speed at which the economy is meeting the Fed’s inflation and employment goals makes this an increasingly challenging exercise. First, I don’t know of any market participant who doesn’t connect the two. Indeed, they must be connected because tapering comes before rate hikes. Second, the Fed still delays tapering while the likely timing of the first rate hike keeps getting pulled forward. The empty space between tapering and rate hikes keeps getting smaller as the two push together, leaving the two connected by default. This is a consequence of basing policy forecasts on the expectation of a slow recovery like that of the last cycle and a resistance to hedge against the possibility of a more rapid recovery.
Powell will be pressed on a range of other topics. Why not taper now if the Fed expects to taper this year anyways? What number on the next employment report will guarantee a taper (in my opinion, the Fed really needs to shift to a more expansive labor market story to delink policy from any one number)? Did the last CPI report confirm the transitory story once and for all? Questions on dots will depend on the dots themselves. What is the Fed’s current view of full employment? Why is the Fed signaling a lessening of financial accommodation when the Black unemployment rate remains elevated? There is an interesting potential outcome that questions about the trading activities of some Fed presidents drive the discussion. I get the sense that journalists see it as an opportunity to explore something beyond the now-tired tapering debate.
The Fed will move toward tapering this week and set the stage for a November announcement assuming no dramatic shift in the economy. The dots will be the focus as they will provide substantial insight into the Fed’s reaction function under the new policy framework. The flexibility of the framework allows for a wide range of interpretations about its implementation.
Good luck and stay safe this week!