Monday Morning Notes, 6/26/23

If You Don’t Have Time This Morning

We anticipate the Fed will raise rates again at the July FOMC meeting and think it likely that either growth or inflation won’t soften enough to prevent a hike at the Oct/Nov meeting. The Fed tends to remain hawkish for longer than market participants anticipate, and this will especially be the case given the costs of being wrong, again, on inflation.

Recent Data and Events

Housing starts leapt higher in May:

Recall from last week that builder confidence rose more than expected in June, suggesting the strength in single family housing will continue. That said, the smaller rise in permits suggests that strength may be overstated:

Even though starts picked up, single-family units under construction fell again as supply continues to catch up with demand. Multi-family units under construction continue to make new record highs. This segment seems ripe for softening next year:

The strength of single-family housing does not surprise us as we anticipated it given the underlying demographics. The Millennial generation is still growing into its peak earning years:

The age of 45 is midpoint of the 35-54 range of peak earning years and note that a bigger number of persons turns 45 each year than the previous year. The largest age group is 32, which means that we are facing 12 years of bigger cohorts of Millennials aging into their peak earning, and spending years. I think that will create an underlying source of demand that makes a return to the pre-pandemic soft path unlikely anytime soon.

In an unusual pattern, initial claims held onto recent gains while continuing claims fell again:

Although on a non-seasonally adjusted basis continuing claims were higher:

At this point, the claims data is another indicator that the labor market has softened compared to 2022. It is not yet evident, however, whether we should view the data as indicating a recession is imminent or as indicating a return to more normal labor markets. I tend toward the latter view, which supports my baseline expectation for an Oct/Nov rate hike. By then the data might be telling a different story.

Fears of an imminent credit crunch that drives a sudden stop of economic activity have not yet been realized:

Still a slow burn that cannot be distinguished from what would have been expected to happen to lending during a rate hike cycle.

The S&P Global preliminary PMIs for June came in on the weak side, particularly the manufacturing component, although as we noted last week persistent softness in manufacturing PMIs has not translated into the harder data.

I see two additional items of interest from the Wall Street Journal. First, a story on why the economy has yet to respond as expected to rate hikes:

“Why haven’t growth and inflation slowed more? Much of the explanation lies in the pandemic’s weird effects and the time it takes for central-bank rate increases to curb economic activity. Additionally, historically tight labor markets have fueled wage gains and consumer spending.”

While the story suggests that policy lags will eventually come into play, we wrote last week that even if they come into play, when they do is still very important for the rates outlook. If the impact of higher rates doesn’t bite harder until 2024, the Fed will hike rates at the Oct/Nov meeting and maybe even again at the January 2024 meeting.

Second, see this story on rising auto insurance rates:

Insurers are getting big bumps because they have suffered big losses. Car insurance premiums could keep increasing through the end of 2024. “Rates need to rise probably 5 to 10 percent in each of the next couple of years, because the loss trends have gone up so much,” said Dale Porfilio, chief insurance officer at industry group Insurance Information Institute.

Soaring insurance premiums are not limited to the auto sector, and they are a reminder that even if shelter and used car prices put downward pressure on inflation, other factors may put upward pressure on inflation. Similarly, watch out for health care costs in 2024:

“While there has been an uptick in the price of gas, food, and other goods and services as a result of inflation, it does not appear to have yet been generally reflected in the medical trend factors used by insurers to set premium rates,” said Harvey Sobel, FSA, a Buck principal and consulting actuary who directed the survey. “As providers renegotiate their fees with insurers, we expect to see higher medical trend factors in the future as medical trends have historically outpaced general inflationary increases.”

It may be premature to become optimistic on inflation even if the Q3 numbers are softer as expected.

Upcoming Data and Events

Key inflation data ahead this week. The week begins with manufacturing orders and new home sales on Tuesday. Wall Street expects that new home sales edged down in May; seems like room for upside surprise given last week’s housing numbers. On Thursday we get the usual initial claims numbers. Regardless of whether you view rising initial claims as an expected side effect of a normalizing labor market or a sign of imminent recession, I suspect market participants will rush to the latter conclusion if claims tick higher. On Friday Wall Street expects to learn that core-PCE inflation was 0.4% in May, which needless to say is too high for the Fed and would offer the possibility that the Fed’s most recent SEP inflation projection remains too low. Also on Friday are the final Michigan confidence numbers for June.

A lighter week for Fedspeak, albeit based on quantity not quality. Only three speakers on the Bloomberg calendar, but with two appearances by Chair Jerome Powell. Powell will speak on Wednesday at the Sintra conference and Thursday at the Bank of Spain. I expect he will stay on message. Also, on Thursday we will hear from Atlanta Federal Reserve President Raphael Bostic who has already said that he doesn’t want to raise rates again this year. We will see if he sticks to that story as the July meeting approaches.

Day	Release	Wall Street	Previous
Tuesday	Capital Goods Non-def ex Air, May P, MoM	0.2%	1.3%
Tuesday	New Home Sales, May	675k	683k
Thursday	Initial Jobless Claims	265k	264k
Friday	Personal Income, May, MoM	0.4%	0.4%
Friday	Personal Consumption, May, MoM	0.2%	0.8%
Friday	PCE Prices, May, MoM	0.1%	0.4%
Friday	Core PCE Prices, May, MoM	0.4%	0.4%
Friday	Univ. Of Mich. Sentiment, Jun. F	63.9	63.9
Friday	Univ. Of Mich. 1Y Inflation Exp., Jun. F	—	3.3%
Friday	Univ. Of Mich. 5-10Y Inflation Exp., Jun. F	—	3.0%

Fed Speak and Discussion

Powell’s appearances on Capitol Hill last week failed to shed any new light on the Fed’s policy path. As expected, Powell largely stuck to the message delivered in the June SEP and the post-FOMC press conference that another two rate hikes this year are a “pretty good guess” if the economy evolves as anticipated. The game we are playing is managing the risk around that forecast, with market participants not surprisingly resisting pricing in the second of those two hikes, given that the Fed has slowed the pace of hikes. That second hike may not happen until the Oct/Nov meeting, which is too far away to have a great deal of certainty over that meeting’s outcome.

Powell and market participants may still be underestimating the resilience of the economy in the back half of 2023. We beat this drum a lot, in part because the economy has consistently surpassed expectations and because it’s the story with the most leverage. Market participants are already tuned to downside risks and will quickly run to rate cuts at the first hint of sustained weakness, particularly if job growth plummets, while few anticipate better-than-expected outcomes on the economy or the Fed’s willingness to continue with rate hikes even if it sees a few months of softer inflation readings.

An interesting example of the Fed misreading the economy is housing. Powell in his written testimony repeated a familiar mantra:

Although growth in consumer spending has picked up this year, activity in the housing sector remains weak, largely reflecting higher mortgage rates. 

This has struck me as odd given that this narrative has for months been at odds with housing data, builder stocks, and builder anecdotes. I wonder if Fed staff have just pushed a narrative of what their models are saying should happen, or a narrative they think their bosses want to hear. Either way, Powell had a sudden epiphany between Wednesday and Thursday of last week:

“So you know housing is very interest, interest sensitive spending, you know, mortgage mortgage rates are — are very sensitive to our policies and and housing construction and housing sales and things like that are very sensitive to mortgage rates. So you saw — you saw housing activity moved down pretty significantly when we started raising rates.

You’ve actually seen it kind of hit a bottom now we actually — we met with some — with the housing group manufacturers, housing builders yesterday and they say business is pretty good. It’s largely new entrants though people, many people have low low rate mortgages that they’re not eager to get out of. And so the sort of strength you see now is new buyers coming into the market.

So the market seems to be improving, but again it’s the most interest sensitive spending or among the most interesting. So it’s going to be affected when we tighten policy.”

Presumably then the SEP forecast incorporates a pessimistic view of housing as apparently the Fed learned just last week that single family housing bottomed out long ago.

In other Fed news, Governor Bowman left the FOMC meeting retaining her reliably hawkish inclinations:

“I supported the FOMC’s decision last week to hold the federal funds rate target range steady and to continue to reduce the Fed’s securities holdings; however, I believe that additional policy rate increases will be necessary to bring inflation down to our target over time. Although tighter monetary policy has had some effect on economic activity and inflation to date, we have seen core inflation essentially plateau since the fall of 2022, and I expect that we will need to increase the federal funds rate further to achieve a sufficiently restrictive stance of monetary policy to meaningfully and durably bring inflation down. I will continue to monitor the incoming data and to look for signs that inflation is on a consistent downward path as I consider appropriate monetary policy at future meetings.”

Bowman anticipates the Fed will continue raising rates, which is not a surprise and follows the SEP projections. Note the last sentence. The idea of looking for inflation to be on a “consistent downward path” suggests that the Fed may need more than Q3 data to be convinced that inflation is reliably heading for its 2% target. That’s a way that we get an Oct/Nov rate hike even if inflation softens in Q3.

San Francisco Federal Reserve President Mary Daly see more rate hikes in the Fed’s future, but the actual outcome is data dependent. Via Reuters:

Compared with projections made in March, Fed policymakers see faster growth, a smaller rise in the unemployment rate, and a shallower drop in inflation, all reflections of generally stronger-than-expected data since then.

“No wonder there’s a couple of extra rate hikes,” Daly said. “More tightening may be required to get the economy sustainably back into balance. But do I know that? No….we are going to have to find the terminal rate by looking at the data.”

Two more quarter-point rate hikes this year, Daly said, is “a very reasonable projection at this point,” she said. “But no decision, for me, has been made.”

The decision for two more hikes hasn’t yet been made, but as you know I believe the decision for another hike has already been made.

Separately, via Market Watch, Richmond Federal Reserve President Tom Barkin said he is looking for more data before supporting a pause:

“I’m still waiting for the haze to clear,” Barkin told reporters after a speech in Richmond, Va.

“I will be very interested in whether I can get convinced that there’s still more to do or I can get convinced that we’ve done enough,” Barkin said.

I don’t know that the “haze” can possibly clear with just the handful of data available by the time of the next meeting, and Barkin clearly has a bias toward further rate hikes. From his speech last week:

“If you back off inflation too soon, inflation comes back stronger, requiring the Fed to do even more, with even more damage. That’s not a risk I want to take.”

I think Barkin would have been fine hiking in June and is ready to hike in July.

Bottom Line

Right now, it’s a waiting game. While a July rate hike is very likely, the Oct/Nov meeting is too far off to price in a rate hike at this time. Moreover, even if likely, we will still need to navigate around possible soft spots in the data, like any impacts to spending from a restart of student loan payments. If growth does not slow sharply, there will be lots of room for market sentiment to swing toward and away from an Oct/Nov rate hike between now and then.

Tim Duy

Chief U.S. Economist, SGH Macro Advisors