If You Don’t Have Any Time This Morning

Newsletter version!

The Fed will cut rates 25bp this week with Powell retaining the option for further cuts depending on data/risks.

Key Data

The economy grew at a better than expected 2.1% pace in the second quarter albeit with an unbalanced pattern of activity. From the Fed’s perspective, they will be happy that growth, supported by a rebound in consumer spending, has not yet slipped below trend. In fact, underlying demand held up quite well. Real final sales to private domestic purchasers rose at a 3.2% rate, pretty comparable to the 3.3% rate for all of last year.

On the other hand, the weakness in business spending – fixed nonresidential investment was down 0.6% – will justify their concerns that business confidence is struggling to overcome slow growth abroad an erratic US trade policy. Also on the negative side, residential housing investment has been negative for the last six quarters; housing hasn’t been driving activity for quite some time. New home sales have effectively flatlined but at least the very soft patch at the end of 2018 seems to be behind us.

While the 4.3% pace of consumption spending is not likely sustainable, the underlying strength likely is sustainable. I have said this before, but I think it is worth repeating: Do not bet against the American consumer in the absence of widespread job losses. With that in mind, note that initial unemployment claims continue to move sideways at very low levels. We have yet to see the upturn in claims consistent with even sharply slowing job growth let alone steep declines in the number of jobs.

Somewhat surprisingly, new orders for nondefense, nonaircraft capital goods continue to hold up. Of course, capital goods orders are not always a leading indicator. See, for example, the slow response of orders in the last recession. That said, they are holding up much better than in the 2015-16 period that followed the oil price crash. Moreover, they certainty belie the claims of any bearish analysts who have been selling recession fears since the end of last year.

Fedspeak

Blackout period last week. The prior week’s Fedspeak was pointing us toward a 25bp rate cut. Perhaps most telling was the rapid rejection of the early interpretationof comments made by New York Federal Reserve President John Williams. His speech argued for a rapid and forceful response to economic weakness when policy rates hovered near the zero-lower bound. Market participants instantly seized upon these remarks as indicating a 50bp cut was in the works. The response was so strong the New York Fed walked back financial markets by stating that Williams’ speech was an academic discussion not a signal about the July Fed meeting. Had Williams been signaling 50bp, he would not have needed to issue such a clarifying statement. Realistically, this incident was something of a rookie error on the part of the New York Fed and suggests that the Federal Reserve in general had not taken seriously the growing chorus of analysts anticipating a 50bp cut. It has been mostly St. Louis Federal Reserve President James Bullard alone willing to push back aggressively on the idea of a 50bp cut.

Upcoming Data

Fairly busy week ahead. Tuesday we get the June report on personal income and outlays with expectations for 0.3% growth in real spending and 0.2% growth in core-PCE prices; subdued low inflation remains important for sustaining the Fed’s dovish feeling. Also Tuesday is the Case-Shiller home price indexes which are expected to reveal that the pace of home price appreciation remains markedly slower than recent years. Wednesday morning we get the ADP employment report while in the afternoon the FOMC will release their decision on rates followed by Federal Reserve Chairman Jerome Powell’s explanatory press conference. Thursday brings the ISM manufacturing report; expectations are the headline number sits at 51.9, just above the breakeven point. Thursday also brings construction spending for June and the usual initial claims report. Then comes Friday and the employment report for July. Wall Street is expecting around 150k job growth and a 3.6% unemployment rate. The Fed will be hard pressed to justify continued rate cuts if job growth hovers closer to 150k and above rather than closer to 100k. Also on Friday comes the trade balance for June and the final reading on July consumer sentiment from the University of Michigan.

Discussion

It’s fairly clear that the Fed will cut interest rates this week, and also fairly clear that they will choose 25bp over 50bp. More interesting will be the guidance we get from the statement and Powell regarding the direction of policy going forward.Where we sit now is that the flow of economic data remains insufficiently pessimistic to justify a rate cut relative to historical Fed policy moves. Yes, data has softened such that the economy appears to be growing closer to trend. No, data does not indicate impending recession. It is not evident to even everyone at the Fed that a rate cut is even necessary.

Moreover, relative to a few months ago, economic pessimism should have lessened. It should be evident at this point, for instance, that any fears of flagging consumer spending were overblown. And, similarly, the housing market is not heading into a 2006 downturn. Some downside risks have even been not just minimized (seems the trade wars are at a bit of a lull) but outright eliminated. The spending deal both nearly eliminates fiscal drag next year while ensuring that the debt ceiling will not be an issue for two years. Assuming the Fed had fiscal drag built into their forecasts, those forecasts will need to be upgraded accordingly.

Still, the Fed will follow through on the rate cut for a number of reasons.It was about risks not about the data, and those risks have not entirely dissipated. Brexit remains an open, festering wound ready to go gangrene. And the lull in the trade wars is almost certainly temporary. Some of the improvement over the first half of the year is attributable to the Fed’s dovish shift: Financial markets remain buoyant and mortgage rates are lower. The Fed will need to follow through with a rate cut to maintain those benefits. With inflation low, the risk of policy error from a 25bp cut is fairly low. And the Fed’s forecasts indicate downward revisions of the natural interest rate, hence policy was tighter than they thought. More succinctly, the December rate hike was simply a small mistake than needs to be rectified.

Unless the data deteriorates or risks intensify, the case for future rate cuts quickly weakens.Powell and his colleagues will need to take this into account in their communications, beginning with the press conference. Powell needs to repeat the mantra that the Fed will aim policy toward sustaining the expansion to maintain a sufficiently dovish tone that keeps financial market participants thinking that rate cuts remain more likely than hikes. At the same time, however, he won’t want market participants to get too far ahead of the Fed and thus will emphasize the data dependent nature of policy. There is lots of room for error when trying to thread this needle, so the press conference might be volatile as Powell flips between the risks and the data.

I think the Fed will be attempting to signal that absent a substantial improvement in the data, the ongoing risks will justify another 25bp rate cut (it would still be a hard sell for the hawks) and that this is expected to be that baseline scenario. But anything more than another 25bp requires more evident deterioration in the outlook or an intensification of risks.Powell will not want to feed into any perceptions that the Fed is already locked into 75bp or more of easing.

Bottom Line: Look for 25bp from the Fed this week with a signal that they are prepared to do more but that they remain data dependent and are not committed to a specific policy path.

If You Don’t Have Any Time This Morning

Split opinions on the Fed about the need for a rate cut argues for 25bp at the end of this month.

Newsletter version!

Key Data

CPI data revealed firmer inflation in June. Pulled higher by apparel and used car and truck prices, core CPI rose 0.3%, its fastest monthly pace since January 2018. June PPI grew at a faster than expected pace, but the headline number was up just 0.1% while PPI excluding food, energy and trade services was flat after more rapid increases of 0.4% in both April and May. It would be tempting to conclude that the firm CPI inflation number in particular would soften the Fed’s resolve to cut rates, but it’s so far just one month and the Fed is more concerned about the possibility that weak growth going forward will weigh on future inflation. The Fed has shifted toward caring less about the threat of higher inflation and more about actual inflation; it will take more than one month for actual inflation to become interesting.

Initial unemployment claims continue to move sideways at low levels. The fact that they have stopped declining suggests a somewhat less vibrant labor market, consistent with the general deceleration of job growth in the first half of 2019. The lack of any substantial rise in claims, however, suggests that claims of imminent recession remain premature.

The Atlanta Federal Reserve’s GDPNow measure currently estimates the economy grew 1.5% in the second quarter. Although this headline number is disappointing, note that the current estimate of final sales to private domestic purchasers is a healthier 3%. The Fed will be more concern about the health of the underlying domestic economic and the business investment numbers than the headline number.

Fedspeak

The highlight of last week was Federal Reserve Chairman Powell’s testimony on the Semiannual Monetary Policy Report.My comments are here; the short version is that Powell made no effort to pull back expectations for a rate cut in July. Notably, he said that the uncertainties in global growth and trade policy had not ebbed since the June FOMC meeting.

The minutes of the June FOMC meeting revealed particular concerns with declining business investment as firms responded to a more uncertain policy environment.These concerns were expected to be long-lasting and induce firms to undergo costly changes in supply chains. This from the Wall Street Journal speaks to such concerns:

Companies that make Crocs shoes, Yeti beer coolers, Roomba vacuums and GoPro cameras are producing goods in other countries to avoid U.S. tariffs of up to 25% on some $250 billion worth of imports from China. Apple Inc.also is considering shifting final assembly of some of its devices out of Chinato avoid U.S. tariffs.

This restructuring of supply chains is likely to continue as business executives have gotten the message that President Trump will not stop using tariffs as a negotiating strategy.Firms would be well advised to avoid concentrating production in any one country; today’s safe haven could easily become tomorrow’s battleground. The Fed is reasonably concerned that such restructuring only distracts firms from new investment and seeks to cushion some of that blow. Note too that these are costs borne by US firms that result in very little net change in the domestic landscape; there is little to suggest that firms are moving production back to the US.

Chicago Federal Reserve President Charles Evans believesthat economic growth is close to trend and is upbeat on the consumer but cautious on investment. He thinks a “couple” of rate cuts would raise inflation. St. Louis Federal Reserve President James Bullard still considers a 25bp rate point cut the appropriate move. If you can’t convince Bullard to move 50bp, it’s tough to see how you get a consensus for 50bp. New York Federal Reserve President John Williams gave a cautious assessment of the economy now that downside risks are higher compared to the beginning of the year. He added that market expectations were in part driving the Fed’s move toward a rate cut. Via Michael Derby at the Wall Street Journal:

Mr. Williams told reporters that part of the reason for lowering rates would be to help keep in place a shift in overall financial conditions that is itself tied to investors’ expectation of rate cuts…“The markets expect cuts so therefore you see lower mortgage rates, you see lower interest rates, and stronger financial conditions broadly, and I think that contributes to more consumer spending and business spending,” Mr. Williams said.

This kind of talk feeds into the perception that the Fed is only cutting rates because the “market” demands a cut. I think the better phrasing would be that rather than dictating policy to the Fed, the market anticipates the Fed will take the appropriate action to sustain the expansion and hence interest rates reflect the expectation of rate cuts.

In contrast, via Bloomberg, Richmond Federal Reserve President Thomas Barkin and Atlanta Federal Reserve President Raphael Bostic questioned the need for rate cuts given the apparently solid economy.

Upcoming Data

This week will be busier than last.Key reports include retail sales and industrial production on Tuesday. The Fed will be looking for signs that consumer spending continues to maintain the bounce that looks evident in the second quarter. Industrial production will give some insight into the degree of the manufacturing slowdown associated with weak global growth and trade policy issues. Wednesday we get housing starts and permits; here we are looking for the impact of lower interest rates on the housing market. I expect incoming data to reveal the housing market has firmed quite a bit after the scare at the end of last year. Thursday we get the usual initial unemployment claims data and on Friday comes the preliminary look at University of Michigan consumer sentiment for July. Powell will give a speech Tuesday titled Aspects of Monetary Policy in the Post-Crisis Era.

Discussion

It still looks like the Fed will opt for 25bp rather than 50bp at the July meeting. The message from Powell and others is that the primary motivation for a rate cut is a recalibration of policy considering greater downside risks while the underlying economy, in the words of Powell, remains in “a very good place.” A 50bp rate cut seems inconsistent with what seems to be the general assessment of the state of the economy.

To get to 50bp at the next meeting likely requires a substantial deterioration of the data that is difficult to see occurring in the next couple of weeks.Something along the lines of particularly weak readings across a variety of indicators – consumer spending, housing, manufacturing, and investment – might do the trick, but no one single indicator would change the tide. To get to 50bp, we need to see fairly substantial evidence that the impacts of an adverse trade policy shock are filtering through to the economy more rapidly than officials have seen up until now.

The same is likely true for the degree of cutting that occurs after this July cut.Again, the Fed is recalibrating policy, not reacting to a turn in the business cycle. At this point, only roughly half of Fed policymakers expect rate cuts this year, and then only 50bp. That argues for Evans’ “couple” of cuts given the current data flow. Obviously, weaker data will yield more rate cuts. At the risk of oversimplification, I would anticipate ultimately 75bp or more of cuts if the preponderance of data begins to suggest that the economy is slowing enough to push unemployment higher.

While the expansion remains intact, the inversion of the yield curve will reasonably induce many to look for a recession.My view is that the yield curve indicates that we should be on recession watch, meaning that conditions are more favorable to recession than at any other point in this expansion, but we are not yet at a point of recession warning. In my opinion, one key factor is that the Fed is cutting rates fairly early in the process; they are not dismissing the yield curve signal as they have done in the past.From the June minutes:

Participants also discussed the decline in yields on longer-term Treasury securities in recent months. Many participants noted that the spread between the 10-year and 3-month Treasury yields was now negative, and several noted that their assessment of the risk of a slowing in the economic expansion had increased based on either the shape of the yield curve or other financial and economic indicators.

If there is anything that would certainly help kill the yield curve as a recession predictor, it would be the Federal Reserve believing that it was a recession predictor.In the past, the Fed has continued hiking after the 10s2s spread inverted; this time they will be cutting without a 10s2s inversion. That policy change should be positive for economy; if the Fed pulls off the soft landing, I would anticipate equity markets to extend recent gains.

Bottom Line: I am still anticipating a 25bp rate cut this month. Policymakers advocating for a rate cut do not appear sufficiently motivated to argue for 50bp while a nontrivial contingent doesn’t believe a rate cut is necessary. It appears that getting consensus on anything more than 25bp would be a challenge considering the current state of the economy.

Federal Reserve Chairman Jerome Powell yesterday did not use his Congressional testimony to walk back market expectations for easier policy. Instead, he effectively confirmed that the Fed intended to cut rates at the end of this month. The Fed is taking out insurance against increasing downside risks given that the cost of that insurance is cheap given low inflation. Eventually future rate cuts will have to be about the data not just the risks.

Powell left little doubt about his policy intentions. Importantly, Powell said that the  downside risks that had vexed the Fed at the June FOMC meeting had not waned. Those downside risks – predominantly trade issues and global growth – threaten to weigh on the economic outlook. Actually, more than just threaten as Powell suggested that the downside outcomes of those risks may already be visible in the data. Looking at the minutes of the June meeting, it appears that the most worrisome of those risks was the decline in investment activity as firms responded to the more uncertain trade environment. This is not expected to be a short-term issue; firms now view this uncertainty as not ending anytime soon.

I believe there is more at play than just the downside risks. The Fed has gradually shifted a key component of its underlying framework. They are very much less worried about the potential for an outbreak of inflation. I think it is tempting to describe this as the death of the Phillips curve, but that would be too dramatic. More accurately I think is that the Fed has little faith in their estimates of the natural rate of unemployment, the rate that is consistent with stable inflation.

Prior to this year, the Fed has held stubbornly to the belief that unemployment must rise from these levels if inflationary pressures were to remain contained. But low unemployment had yet to trigger higher inflation and by the March Summary of Economic Projections the median interest rate forecast no longer assumed the Fed would need to rates above neutral to slow the economy and ease unemployment higher. That reflected less confidence in their estimates of the natural rate of unemployment and more emphasis on actual over expected inflation outcomes.

In addition to less confidence about the value attached to the natural rate of unemployment, the Fed increasingly recognizes the value of persistently low unemployment. Both of these issues were visible in Powell’s responses to questions yesterday. This meant the Fed had become more cautious about derailing job growth via higher interest rates and more willing to risk somewhat higher inflation to sustain the expansion.

These shifts, couple with evidence of a slowing economy, allowed the Fed to shift to neutral and stop hiking rates as had been expected just last December.  What pushed them over the edge to a rate cut was the potential disruption triggered by President Trump’s repeated use of tariffs as a negotiating club. The uncertainty caused by the actions was sapping business confidence and threatening to force force to endure the costly process of reworking current global supply chains. The Fed felt they had little choice but the respond with lower rates just as they would with any adverse economic shock.

In other words, Trump got the Fed to cut rates, but had to damage the economy to do it.

Bottom Line: The Fed will cut rates 25bp cut this month; I still think 50bp would be too high given that this is an insurance cut rather than a reaction to the data. Considering the shift of dots in the June SEP, the odds favor that the Fed follows with another 25bp. Beyond that depends on the extent to which the economy is able to manage the Trump trade shocks.

If You Don’t Have Any Time This Morning

The Fed will likely cut rates this month, but the data doesn’t support a 50bp move.

Newsletter version.

Data

The employment surprised on the upside as firms added 224k employees in June. Needless to say, 224k remains a healthy pace of job growth that belies both claims of impending recession and the expectation of deep interest rate cuts. While it is tempting to say that the June report offsets May’s, this latest report does not undo narrative that the labor market slowed in 2019.Notably, May’s report delivered large downward revisions to previous months; there were no such countervailing upward revisions in June’s. Absent such revisions, the June report looks like a good outcome around an underlying pace of growth that has slowed markedly since the final months of 2018.

Weaker wage growth in recent months also suggests a change in the weather.There too we see a shift downward in wage growth from above to below 3%. The lower wage growth should catch the Fed’s eye. While it is not necessarily the case that faster wage growth feeds directly into inflation, it seems very unlikely that faster inflation could be sustained absent rapid wage growth. The wage numbers thus fit nicely into the narrative that inflation concerns should really remain on the back burner.

The ISM reports came in largely as might be expected given the apparent slowdown in overall economic activity.The manufacturing sector has clearly slowed with the new order measure now flirting with the breakeven mark. That said, these numbers are not unlike what has been seen many times throughout this expansion; this is the third time (2011-12, 2015-16, and now) the manufacturing sector has eased back over the past ten years. In contrast, while the service sector measure has also fallen, the composite index remains well above the breakeven mark and has throughout the expansion. The service sector is a much larger part of the economy. It is very difficult to believe that the economy would enter recession on manufacturing alone.The service sector would need to join it in recession, and so far that is clearly not the case.

Fedspeak

Fed speak has been fairly light in recent weeks but what we have points toward a 25bp cut rather than the beginning of a series of cuts. Notably, in a Bloomberg interviewSt. Louis Federal Reserve President James Bullard pushed back on the notion of 50bp saying that such a move would be overdone. He specifically referred to any impending action as “insurance”:

“Inflation is running low, inflation expectations are running low, and you would like to get those back up to 2%,” he said. “I don’t think you have to take huge action to get this. This is more in the realm of insurance.’’

Federal Reserve Chairman Jerome Powell largely reiterated the themes of the most recent post-FOMC press conference in a recent speech. That said, it appears that he too was attempting to push back on growing market expectations for a period of substantial rate cuts:

Many FOMC participants judge that the case for somewhat more accommodative policy has strengthened. But we are also mindful that monetary policy should not overreact to any individual data point or short-term swing in sentiment.

Powell also noted during Q&A that “an ounce of prevention is worth a pound of cure.” One other point from Powell’s speech is that emphasis on the benefits of low unemployment:

Like many others at the conference, I was particularly struck by two panels that included people who work every day in low- and middle-income communities. What we heard, loud and clear, was that today’s tight labor markets mean that the benefits of this long recovery are now reaching these communities to a degree that has not been felt for many years. We heard of companies, communities, and schools working together to bring employers the productive workers they need—and of employers working creatively to structure jobs so that employees can do their jobs while coping with the demands of family and life beyond the workplace. We heard that many people who, in the past, struggled to stay in the workforce are now getting an opportunity to add new and better chapters to their life stories. All of this underscores how important it is to sustain this expansion.

The focus away from inflation and toward employment is important. In a low inflation environment, the Fed’s fight has shifted to the benefits of sustaining the expansion and with it persistently low unemployment. That argues for a more careful and on net dovish policy approach.

Not everyone at the Fed is sold on a rate cut. Cleveland Federal Reserve President Loretta Mester argues against cutting rates:

Cutting rates at this juncture could reinforce negative sentiment about a deterioration in the outlook even if this is not the baseline view, and could encourage financial imbalances given the current level of interest rates, which would be counterproductive.

She prefers instead to hold rates steady and allow for inflation to gradually edge higher given her baseline outlook of steady continued economic growth.

Upcoming Data

Fairly light data this week. The main event is the CPI report, released Thursday. Wall Street is expecting a flat headline number but a 0.2% rise in core inflation, a combination that will support the Fed dovish tendencies.On Thursday we also get the usual initial claims report. Other notable reports are wholesale inventories on Wednesday and we get another reading on price pressures with the PPI report on Friday.

The main Fed event this week is Powell’s appearance in Congress to deliver the Semiannual Monetary Policy report (House on Wednesday, Senate on Thursday). Also, we should keep an eye on Federal Reserve Governor Randal Quarles’ speech on Thursday titled Financial Regulation and Monetary Policy. With stocks again making record highs amidst a persistently low inflation environment, the interplay of monetary policy and financial stability remains something not far from the minds of central bankers.

Discussion

It looks like market participants got too far ahead of the Fed in the last few weeks. There has yet to be a sufficient weakening of the data to justify a 50bp cut this month let alone a long series of rate cuts. Moreover, it really isn’t that difficult to make the case for stable policy that Mester made this past week. Absent the dovish shift in Fedspeak in recent weeks, and the lack of pushback against the generally dovish interpretation, the data flow would likely have not alone have driven expectations as far as they had gone.

Why are rate cuts even part of the discussion? I think that we have to look back to the final months of 2018 to answer that question. From the Fed’s perspective, the economy was quite strong and showed few signs of slowing. Notably, the pace of job growth was still on an upward trend, fueling concerns that the economy would soon overheat. Had the Fed anticipated the overall softening of activity and in particular the decline in job growth since then, I suspect they would not have followed through with the December rate hike. 

In this light, a rate cut this month is simply a correction of the fairly small error made in December.The need to correct that error became important given growing downside risks from trade tensions and slower global growth. There is no need to risk a sharp slowing in the economy given that inflation remains low. Moreover, if the Fed wants to sustain the expansion, they cannot delay a rate hike until the data reveals that a recession is underway.That just guarantees they would soon again find themselves at zero interest rates. All of this argues for an insurance cut rather than a panic cut. That means 25bp, not 50bp.

Furthermore, the story does not add up to one in which the Fed foresees multiple rate cuts. The most recent SEP forecasts reveal that seven participants expect 50bp of rate cutting in total this year, one expects 25bp, eight expect no change, and just one expects another rate hike. Given that, as Powell has said, that all virtually all participants believed the case of additional accommodation has risen, the odds favor the group moving toward the 50bp direction. But we won’t get there without more data.

Where we will get without more data is an insurance cut. But after that, the more hawkish participants are going to start digging in their heels against further cuts. At the risk of oversimplifying, I expect that if the economic environment looks to be generating job growth around 150-175k, the Fed will likely cut rates once that then shift back to patient mode. If we are seeing a situation emerge where job growth is likely to slide to 100k, the Fed will deliver another 25bp. Less than 100k will bring another.

To be sure, these scenarios hinge on a continued quiescent inflation outlook.A dovish Fed is one that faces few inflationary pressures. The Fed will tolerate modest overshooting of the target, but will get nervous if inflation looks to be heading sustainable above 2.5%. There seems like little risk of this now, but certainly something to keep an eye on. Also, we don’t know how the Fed will react to record high equity prices. The Fed wants to sustain the recovery, but doesn’t want a repeat of the late-90s either. And we don’t know what other trade/global risks will emerge in the second half of the year.

Bottom Line: The data is not supporting a 50bp cut, nor does there seem to be much stomach for a such a move at the Fed. The story emerging is one of an insurance cut to reverse December’s hike. A 25 basis point cut this month looks likely; given the dovish direction of the Fed as revealed in the SEP, the odds favor still another 25bp, but that looks more fragile than I believe a few weeks ago.