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Wall Street Futures tumbled early Tuesday on the January PMI report, showing substantial wage and input price growth. Also, subdued report cards from 3M and GM (earnings and guidance) dragged the market. On Tuesday, the S&P Global PMI flash data shows U.S. Manufacturing PMI increased to 46.8 in January from 46.2 in December, above market expectations of 46.0. But the flash reading continued to point to another contraction in U.S. factory activity which was the second-fastest since May’20 as manufacturing demand conditions remained subdued. Output contracted following another sharp drop in new order inflows, with firms highlighting the impact greater costs were having on client demand.
The rate of decline in new business was the second-fastest in over two-and-a-half years and firms cut their workforce numbers for the first time since July 2020. On the price front, input costs increased at a faster pace, ending a sequence of moderation in cost inflation that began in mid-2022 while output prices also rose. Vendor performance deteriorated only marginally, with supply chain disruption much reduced from that seen in 2022.
The S&P Global flash data shows US Services PMI increased to 46.6 in January, up from 44.7 in December and above market expectations of 45.0. The latest reading signaled a solid fall in service sector output, but one that was the softest since last October, amid customer hesitancy and high inflation. The decrease in new business was only marginal overall, while employment rose only fractionally and backlogs of work declined further. On the price front, input cost inflation accelerated and output price inflation was unchanged from December. Finally, business confidence reached a four-month high amid hopes that domestic and external demand conditions improve.
Finally, the S&P Global flash data shows U.S. Composite PMI improved to 46.6 in January from 45.0 in the previous month but still pointed to a seventh consecutive month of contraction in the private sector activity. Activity in both service and manufacturing sectors fell at a slower pace, even as companies continued to highlight subdued customer demand and the impact of high inflation on client spending. New orders dropped the least for three months amid high inflation, rising interest rates, and customer hesitancy, while employment rose marginally and backlogs of work decreased solidly. On the price front, input cost inflation quickened from December, bringing to an end a seven-month sequence of moderating rises, while the rate of output charge inflation was unchanged. Finally, business confidence strengthened to a four-month high, amid hopes of a resurgence in customer demand as 2023 progresses.
S&P Global said despite slowing economic activities and a cooling labor market, input cost pressure increased again along with wage pressure, especially in the service industry, which may force Fed for a faster tightening/higher terminal rate than the market is expecting.
“The US economy has started 2023 on a disappointingly soft note, with business activity contracting sharply again in January. Although moderating compared to December, the rate of decline is among the steepest seen since the global financial crisis, reflecting falling activity across both manufacturing and services. Jobs growth has also cooled, with January seeing a far weaker increase in payroll numbers than evident throughout much of last year, reflecting a hesitancy to expand capacity in the face of uncertain trading conditions in the months ahead. Although the survey saw a moderation in the rate of order book losses and an encouraging upturn in business sentiment, the overall level of confidence remains subdued by historical standards.
Companies cite concerns over the ongoing impact of high prices and rising interest rates, as well as lingering worries over supply and labor shortages. The worry is that not only has the survey indicated a downturn in economic activity at the start of the year, but the rate of input cost inflation has accelerated into the new year, linked in part to upward wage pressures, which could encourage a further aggressive tightening of Fed policy despite rising recession risks.”
On Tuesday, Dow Future slips over -300 points from around 32750 to 33474 after S&P Global PMI data reveals higher input cost pressure for the 1st time after mid-2022. But Dow Future also recovered to almost 33850 after a news headline U.S. may provide Ukraine M1 Abrams battle tanks; Poland and Germany may also provide similar heavy battle tanks to Ukraine. Overall, this may further escalate Russia-Ukraine/NATO geopolitical tensions and economic sanctions without any signs of a truce. Some market participants are also worried about the nuclear dooms day as Putin may not accept any loss in a conventional war. Finland and Sweden are also ready to join the NATO alliance. This may infuriate Putin/Russia more on Russian security issues.
All these games of war are positive for industrial and defense/military-related stocks, which are the biggest beneficiaries of the lingering Russia-Ukraine war (apart from oil stocks). Increasing defense/military spending by various countries including Japan, South Korea, Taiwan, Germany, France, Italy, U.S. China, Russia and also India is also acting as a big fiscal stimulus in addition to normal infra capex. On Tuesday, Wall Street was boosted by industrials, real estate, consumer staples, banks & financials, and utilities to some extent, while dragged by healthcare, communication services, materials, consumer discretionary, and techs. The market was also boosted on hopes of blockbuster earnings by blue chips ahead of a deluge of the report card.
The market is now expecting slower Fed hikes at +25 bps in the coming months instead +50 bps as U.S. core inflation is gradually easing but still substantially higher than +2.00% targets, while employment is almost at maximum levels. Fed will now go for now around a 5.25-5.50% terminal rate by May-June’23 and then hold there for at least till Dec 23-June’24 to bring down core inflation back to +2.00% targets, ensuring minimum damage to the labor market (employment) and overall economic growths; i.e. soft/softish landing despite substantial rate hikes to bring price stability.
On 19th January, ahead of Fed’s blackout period for the 2nd February policy decision, Fed’s VC Brainard, an influential FOMC official, indicated a slower pace of rate hikes, but a higher terminal rate than the market is now expecting. Brainard said in her speech titled: “Staying the Course to Bring Inflation Down”
Inflation has declined in recent months, which is important for American households, businesses, and consumers. Inflation is high, and it will take time and resolve to get it back down to 2 percent. We are determined to stay the course.
Financial conditions have tightened considerably over the last year as the Federal Reserve and foreign central banks have tightened policy. Real yields have risen significantly across the curve over the past year: 2-year yields on Treasury Inflation-Protected Securities (TIPS) have risen more than 4-1/2 percentage points to 2.1 percent, and 10-year TIPS yields have risen more than 2-1/4 percentage points to 1.2 percent. Short-term real interest rates have moved into decidedly positive territory. Mortgage rates have doubled.
Inflation has been declining over the past several months against a backdrop of moderate growth; Yesterday's industrial production index points to a significant weakening in the manufacturing sector, and the retail sales report points to a further moderation in consumer spending. Looking forward, weaker readings on real income, wealth, and sentiment, along with indicators of spending on services, such as the ISM services index, point to subdued growth in 2023. Real disposable personal income declined, on the net, at an annual rate of 4.1 percent in the first three quarters of 2022, suggesting that recent consumption has been supported by running down pandemic savings and greater reliance on credit. In particular, savings among low-income households appear to be lower and to have declined more rapidly than was previously appreciated.
The widespread expectation for U.S. growth to be below potential over 2022 and 2023 reflects significant tightening in both fiscal and monetary policy in an environment of broader global tightening. The expiration of the previous fiscal stimulus imposed a substantial drag on real U.S. gross domestic product (GDP) growth in 2022, whereas fiscal policy is expected to make a modest contribution over the next few years, in line with its longer-run average.
By contrast, the drag on U.S. growth and employment from monetary policy is likely to increase in 2023 because of transmission lags from the rapid, large swing from accommodation to restraint in 2022. From March to December 2022, the Federal Open Market Committee (FOMC) undertook a large cumulative tightening in the stance of monetary policy by raising the policy rate by 4-1/4 percentage points and shrinking the balance sheet.
Although financial conditions adjust immediately to reflect expected and actual changes in monetary policy, the full adjustment of output, employment, and inflation occur with a lag. Given the speed and magnitude of the swing in the stance of monetary policy, the lagged effects of earlier accommodation likely offset some of the initial effects of tightening over the course of 2022, and it is likely that the full effect on demand, employment, and inflation of the cumulative tightening that is in the pipeline still lies ahead. That said, there is uncertainty about the timing and magnitude.
With that in mind, let's turn to the implications for the employment leg of our dual mandate. In contrast to the slowing of output growth, labor markets remained tight throughout 2022, with layoffs remaining below pre-pandemic levels and the unemployment rate ending the year at 3.5 percent, its historical low. Quit rates and the ratio of job postings to job seekers also remain elevated, although they are off their peaks from early in the year.
Recent declines in average weekly hours, temporary-help services, and monthly payroll growth suggest tentative signs that labor demand is cooling. Employment at temporary-help services firms—a good leading indicator—peaked in July 2022 and has been declining since then, ending the year only slightly above its December 2019 level. Similarly, average weekly hours have declined: After peaking in early 2021 and remaining elevated through May 2022, average weekly hours have declined and now stand at the bottom of the range for this metric over the five years before the pandemic.
The continued decline in average weekly hours is notable because this margin is among the easiest to adjust by firms facing declining demand, especially those who may be reluctant to undertake layoffs following the challenges encountered in restoring employment following the pandemic-induced layoffs. In addition, average payroll growth in the Bureau of Labor Statistics establishment survey fell from 540,000 jobs per month in the first quarter of 2022 to 250,000 jobs per month in the fourth quarter.
That said, labor supply appears likely to remain constrained. On net, the labor force participation rate flattened out over 2022 at a level that is about 1 percentage point lower than pre-pandemic, primarily reflecting an estimated 2.5 million in excess retirements, as well as some impact from long COVID.8 Immigration has also been low in recent years.
Despite constrained supply, wages do not appear to be driving inflation in a 1970s-style wage–price spiral. Wages have indeed grown faster than the pace consistent with 2 percent inflation and productivity growth. It is also true that wages have grown slower than inflation over the past two years, and that aggregate real wages have fallen. It appears that workers in lower-wage sectors who saw high pandemic layoffs initially and benefited from job switching subsequently as businesses scrambled to hire have seen wage gains in real terms.
However, in the aggregate, the gains among lower-wage workers were more than offset by real wage declines among middle- and higher-wage workers in the context of a broader compression in the real wage distribution, as David Autor points out. Overall, the labor share of income has declined over the past two years and appears to be at or below pre-pandemic levels, while corporate profits as a share of GDP remain near postwar highs.
Retail markups in a number of sectors have seen material increases in what could be described as a price–price spiral, whereby final prices have risen by more than the increases in input prices. The compression of these markups as supply constraints ease, inventories rise, and demand cools could contribute to disinflationary pressures.
There are tentative signs that wage growth is moderating. Growth in average hourly earnings has softened recently—stepping down to 4.1 percent annualized growth on a 3-month basis in December from roughly 4.5 percent on a 6-month and 12-month basis. I will be watching to see whether the employment cost index data at the end of this month show the deceleration from the third quarter continuing into the fourth quarter.
Let's now turn to the inflation leg of our dual mandate. Inflation has declined in recent months from very high levels. With the consumer price index and producer price index now available, total PCE (personal consumption expenditures) inflation in December is likely to have run at around a 2.3 percent annualized pace on a 3- and 6-month basis, as compared with 5.1 percent on a 12-month basis. This deceleration reflects an easing in war-related energy shocks as well as in core goods inflation: Energy and core goods each subtracted nearly three-fourths of a percentage point from 3-month annualized total PCE inflation. The declines in energy and core goods are a reversal of previous large increases and are expected to moderate.
Core PCE inflation is running at a 3.1 percent annualized pace on a 3-month basis—below its 3.8 percent reading on a 6-month basis and 4.5 percent on a 12-month basis. Within this, recent declines in core goods inflation reflect a reduction in core import prices, an easing of supply chains, a restocking of inventories, and cooling demand. Core goods prices are likely to flatten out once earlier large gains reverse, in the absence of new shocks, and overall core inflation could move up somewhat for a time as a result.
In that regard, housing services inflation remains stubbornly high at 8.8 percent on a 3-month basis—compared with 7.7 percent on a 12-month basis. Housing services are making an annualized contribution to core PCE that is more than double their contribution before the pandemic. That said, the housing sector is highly interest-sensitive, and the most recent reading of one national indicator pointed to house prices have declined 2.5 percent over the five months ending in November. Similarly, rents based on new leases are decelerating sharply. Although it is currently offset by a catch-up in renewing leases, the decline in rent on new leases will show through to average rent over time, and declines in housing services inflation are expected by the third quarter of this year.
In addition, non-housing services are running at about 4.4 percent annualized inflation on a 3-month basis, similar to their 12-month pace. There are a range of views on what it will take to bring down this component of inflation to pre-pandemic levels. Since wages constitute a significant fraction of costs for most firms in non-housing services, one possible channel is through a weakening in labor demand. That said, to the extent that inputs other than wages may have been responsible in part for important price increases for some non-housing service sectors, an unwinding of these factors could help bring down non-housing services inflation.
There is some recent evidence that the persistent components of inflation in core goods and non-housing services, particularly transportation, recreation, food services, and accommodation, have behaved similarly, peaking around early 2022 and steadily declining since then. To the extent that the persistent components of these non-housing services and core goods reflect common factors that are fading, such as pass-through from commodity and supply chain shocks, they are unlikely to be as cyclically persistent, as long as inflation expectations are well anchored.1
Of course, an extended period of high goods and services inflation resulting from a series of demand and supply shocks associated with the pandemic and the war could lead to a rise in inflation expectations, which would make it much more difficult to bring inflation down. That is why it has been important for monetary policy to take a risk-management posture to defend the expectations anchor. And the evidence from the market- and survey-based measures suggests that longer-term inflation expectations are well anchored, while year-ahead measures have recently declined but remain elevated.
Together, the price trends in core goods and non-housing services, the tentative indications of some deceleration in wages, the evidence of anchored expectations, and the scope for margin compression may provide some reassurance that we are not currently experiencing a 1970s‑style wage–price spiral. For these reasons, it remains possible that a continued moderation in aggregate demand could facilitate continued easing in the labor market and a reduction in inflation without a significant loss of employment.
Nonetheless, substantial uncertainty remains. Further shocks associated with the war and the pandemic are possible. While there has been some improvement in the outlook for activity and inflation in Europe, there is uncertainty about the implications of China's exit from zero COVID for global demand and inflation, especially in commodities.
Turning to the implications for policy, my colleagues and I are committed to restoring price stability. The FOMC moved policy into the restrictive territory at a rapid pace and subsequently down-shifted the pace of increases in the target range at its most recent meeting. This will enable us to assess more data as we move the policy rate closer to a sufficiently restrictive level, taking into account the risks around our dual-mandate goals. In parallel, balance sheet runoff is continuing. Even with the recent moderation, inflation remains high, and policy will need to be sufficiently restrictive for some time to make sure inflation returns to 2 percent on a sustained basis.
As the U.S. economy, labor market as well as core inflation is cooling down, but still, substantially above +2.00% targets, Fed may shift to slower rate hikes (calibrated tightening) to ensure a soft/softish safe landing instead a bumpy hard landing (an all-out lingering recession). Thus Fed may now go for +25 bps rate hikes each on 2nd February, 22nd March, and 3rd May to arrive at a preliminary terminal rate of +5.25% (from present +4.50%) in line with the December SEP.
The FFR is now forecasting an almost 95% probability of a +25 bps rate hike on 2nd February and Fed is not engaged in ultra-hawkish jawboning to negate that forecast just ahead of the blackout period. History shows that Fed never goes for any policy rate action against the market consensus or without taking the market into confidence (through well-orchestrated jawboning/communications). This ensures orderly market reaction/function.
Looking ahead, Fed will watch the trajectory of core inflation from Dec’22 to May’23 (6M rolling average). Presently, the core CPI average is around +6.00%, while the December reading was +5.70%. If the 6M rolling average of core CPI indeed comes down to around 5.00% by June’23, then Fed may keep the terminal rate around +5.25%. Alternatively, if the 6M rolling average of core CPI falls to +5.25%, then Fed may go for another +25 bps hike in June for a terminal rate of around +5.50%. In the worst-case scenario, if the 6M rolling average of core CPI sticks to around +5.50% or +5.75% by May’23. Then Fed may opt for further rate hikes @25 bps to reach +5.75% or +6.00%.
As per the pre-COVID trend and comments by Fed Chair Powell, Fed may like to keep the terminal rate at least above 25 bps of average core CPI to have a real positive rate (wrt at least core inflation). And if average core CPI indeed falls well below 4% on a sustainable basis by June’24 due to rate hikes, QT-financial tightening, and easing of supply disruptions, then Fed may also go for calibrated rate cuts ahead of Nov’24 U.S. Presidential election to boost up the economy and employment/labor market. In the meantime, Fed is ready to allow the U.S. unemployment rate to soar to 4.5-4.7% to bring down core inflation towards +2.00% targets.
Fed is now signaling a soft/softish landing; i.e. solid labor market and steady economic growth despite considerably higher borrowing costs. As the balance sheets of both U.S. Households and Corporates are now rock solid (deleveraged) and cash-rich, consumer spending is also robust. The U.S. economy is now slowing down. But the U.S. employment is still almost at the Fed’s maximum level despite some cooling, while average core inflation at around +5.5% (core CPI/PCE) is still substantially above the Fed’s price stability target of +2.00% without any meaningful sign of cooling. For a goldilocks-type U.S. of economy, Fed needs at least 4% unemployment and a 2% core inflation rate on average to fulfill its dual mandate of maximum employment with price stability.
As U.S. core inflation is now around +6.0% on average in 2022, substantially above Fed’s +2.0% targets but the average unemployment rate at 3.6% is almost around pre-COVID/lifetime low of 3.5% and also below Fed’s preferred/goldilocks run rate 4.0%. Thus Fed now prefers to bring core inflation down to +2.0% levels by calibrated tightening as there is enough policy space for a maximum employment mandate. Fed is now even ready to tolerate 4.5-4.7% unemployment levels (from present 3.5-3.7%) to bring core inflation down to around +2.00% (from present levels of +6.00%).
Fed will do this job by keeping financial (Wall Street) stability in a calibrated manner/jawboning as the financial market functions on expectations, not the real outcome. Fed may go for calibrated tightening (75-100 bps) by Feb-May-June’23 for a terminal rate of 5.25-5.50% and then pause. Fed is now emphasizing the proper balancing of inflation management and economic growth for a softer/softish landing.
Thus Fed is now jawboning the market for a real positive rate (at least wrt average core inflation -CPI/PCE) of +5.50%. Fed is now preparing the market for a slower rate of increase, but higher for longer. Fed will now focus on an appropriate terminal rate, restrictive enough (real positive) to bring down inflation towards the +2% target over the medium term. When the cost of borrowing turns real positive or there is an elevated cost of capital, overall economic activity/demand bounds to slow down, leading to lower inflation (as lower demand will try to catch up with the presently constrained supply capacity of the economy). Also, a real positive rate would encourage savings than spending, negative for inflation.
As per Taylor’s rule, for the US:
Recommended policy rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(5.5-2.00) =0+2+3.5=5.5%
Here for U.S. /Fed
A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= average core inflation=5.5% (average of core PCE and CPI)
Thus Fed will hike further 75-100 bps by Mar’23 to 5.25-5.50% depending upon the actual core inflation trajectory in Q1CY23. Fed is now preparing the market for a possible series of smaller hikes (25 bps) and pauses down the road after reaching around 5.25-5.50% by May’-June’23. But Fed also seems confused about levels of an appropriate terminal rate and may continue to debate. Fed may keep the terminal rate around +5.50% for at least 2023 to bring down core PCE inflation back to +2.00% on a sustainable basis.
Fed is now preparing the market for terminal rates around 5.25-5.50% and stay there until at least Dec’23 or Mar’24. And Mar’24, if core PCE inflation stabilizes around +2.0% targets, and unemployment goes up around 4.5%, then Fed may also go for some rate cuts and even launch QE-5 ahead of Nov’24 U.S. Presidential election to have a ‘feel good’ factor for both Wall and Main Street. The U.S. is now paying around 11% of its tax revenue as interest on public debt, while Europe, U.K. China pays around 5.5% and Japan around 15%. As a developed economy and the world’s largest debtor, the U.S. has to ensure lower pre-COVID borrowing costs of around 8.5% in the coming years; otherwise, it would be seen as a fiscal blunder.
Fed will consider at least two-quarters of average core inflation in 2023 for its rate actions. After reaching +5.25% by May, Fed may pause if core inflation trends a definitive downtrend and falls below +5.00% on a sustainable basis; otherwise, Fed may even go for +6.00% repo rates by Sep’23.
Fed’s Bullard wants a 5.25-5.50% terminal rate by June’23 and then a pause to assess. Bullard also wants an extended period of QT. In contrast, most other Fed officials including Waller, Brainard, Mester, and Harker seek a terminal rate of around 5.00-5.25%. As the current US10Y bond yield is around +3.40%, much lower than the Fed’s projection of a terminal rate of +5.25% till at least Dec’23, the market is now expecting Fed rate cuts by late 2023. Thus Fed is now jawboning in a balancing way so that 1Y inflation expectations do not jump again after the recent easing. Fed is aiming for price/Wall Street stability along with a soft/softish landing. The market is now expecting +25 bps rate hikes each in Feb, March, and May for a terminal rate of +5.25% by May’23. On Friday Fed’s Waller also virtually started the debate about rate cuts in 2024 in his Q&A session.
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