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Issue 37: The Fed Takes a Breather

June 20, 2023

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The Fed Takes a Breather

Looks more like a “skip” than a “pause”
US central bankers chose to hold tight at Wednesday’s June FOMC, leaving rates unchanged for the first time in fifteen months. Though that was the odds-on favorite outcome among those placing futures bets, and despite tentative trading in the immediate aftermath of the meeting as markets processed the meeting and press conference, stock ended the week with a rally, pushing the S&P 500 to its fifth winning week in a row. That puts the index 9% away from its record high, set in January of last year. This exuberant reaction leaves us wondering how investors will take it if the Fed resumes raising rates in July—making this a “skip” rather than a “pause,” the latter of which would entail holding rates steady for longer. That’s certainly what traders expect, with the probability of a July hike implied by Fed Funds futures popping from 65% just before the FOMC to nearly 75% by the end of the week. Data from the committee members themselves clearly support those projections, with median entries to the FOMC dot plot (see below) reflecting two more quarter-point hikes taking place by year end, putting the terminal rate for this cycle at 5.6% (vs. an expectation the policy rate would peak at 5.1% from last quarter’s poll).

Figure 1 Implied FED Funds Target Rate

Why did the Fed hold off, and was it wise?
We view this as a hawkish pause and agree with the consensus belief that the Fed will be back in action next month. So why didn’t they hike at this meeting? Think of the move as tactics rather than strategy. As the dot plot above suggests, pretty much everyone on the committee sees the need for further increases to benchmark rates to get the Fed’s job done. But in the short run, officials perceived big benefits to slowing down. For one, the central bank wants more time to understand how past hikes have impacted the economy, including what to make of March’s banking crisis. Moreover, notwithstanding the Fed’s independence, one imagines the recent debt-ceiling crisis and heavy expected issuance by the Treasury—another source of tightening—played into the Fed’s decision making. Finally, Powell’s post-meeting remarks cited the most obvious rationale for taking a meeting off: “As we get closer to the destination…it’s common sense to go a little slower.” We tend to agree with a cautious approach, which mitigates the risk of an overshoot. Of course, the alternate risk in taking a break is that Fed officials open the door to a premature end to tightening in the event that data coming in between now and July can’t justify a resumption of hikes. In that case, it’s hard to see inflation coming down to the 2% target, we could see a “target” give way to a “range” on inflation, and the Fed would lose serious credibility.


On jobs, a bit of a shift in the Fed’s narrative
Though Jay Powell acknowledged in his post-meeting comments that he’s seeing “only the earliest signs of disinflation” in macro data on core non-housing services, he has observed that the right elements are coming together. Along those lines, we have noted that in recent Fed meetings, there has been some movement in the way officials talk about how labor conditions impact inflation. For several months, Powell had been portraying the remarkable strength of the US job market as the primary driver for inflation in non-housing services. During the May meeting, however, he backtracked a bit, proposing that wages are probably not the primary driver of inflation after all, instead emphasizing the robustness of US jobs as a supportive factor for growth, as opposed to an inflationary risk. It wouldn’t be a stretch to interpret the Fed’s highlighting positive aspects of a tight labor market as a sign they’re no longer quite so fixated on increasing unemployment as a means of curbing inflation. That flies in the face of the classic Phillips curve model, directly linking inflation and employment, but it does jibe with the last year of significantly moderating inflation without corresponding job losses. Whether these dynamics will get us back to a tolerable level of inflation is another story.

Deep Dive on Last Week’s CPI

May continued happy trends in headline CPI
Speaking of inflation, last week’s FOMC deliberations overlapped with the US Bureau of Labor Statistics (BLS) inflation report, giving Fed officials a bit more data to work with. Indeed, BLS figures probably helped in the decision to skip, as May’s headline CPI was rather soft, recording a year-over-year increase in consumer prices of 4%, the smallest growth witnessed since March 2021. Some of the underlying details were also promising, beginning with a decline in the number of categories that experienced extreme price increases versus prior months. As of May, only 56.4% of CPI components, by weight, are showing an inflation rate exceeding 4% on an annualized basis—the lowest such reading since September 2021—while only around 15% of the index is experiencing inflation rates more than one standard deviation above their historical average. We also note that although used cars and trucks alone accounted for a 0.12% increase in month-on-month inflation for May, the Manheim used-car price index, a more timely indicator based on wholesale car auction data, suggests that their impact could soon shift from being a significant inflator to a drag on the numbers. Even more promising, although hotel price volatility drove an increase in CPI shelter costs, May witnessed deceleration in rents, which account for the largest portion of the index by weight, the third consecutive month of slowing.


Progress on core inflation too slow for our liking
As we’ve remarked many times before, things are a little less rosy when one looks at the core: inflation excluding volatile food and energy prices. This measure, which the Fed considers a better gauge of underlying price pressures, remained elevated in May, rising 5.3% year-over-year and notching a third consecutive 0.4% increase on the month, approximately double the pace seen before the pandemic, according to the BLS. Most of the progress we’ve seen has been in headline CPI, on track to reach the Fed’s target by year end, whereas core inflation—though certainly headed in the right direction—won’t be back to 2% any time soon (see below).

Figure 2 Trend in Headline CPI & Core CPI

Part of what the Fed worries about—and what would thus spur further hikes in July and beyond—is the idea of inflation becoming entrenched. In that vein, some analysts have argued that the longer inflation remains around 5%, the more challenging it could be to get back to the Fed’s target. Both price and wage inflation are expected to come down, though that latter at a slower pace. The result of this divergence would be an increase in real wages, which has positive implications for economic growth and consumer demand, but would in turn give companies reason not to lower prices. Even expectations can become ingrained, another source of anxiety for the Fed. Preliminary readings in the June survey of consumers by the University of Michigan brought some solace on that front, as one-year inflation expectations dropped to 3.3% from 4.2% in May. At the same time, five-year inflation expectations remained at around 3%, which won’t give the FOMC comfort as another big decision looms in one month’s time.

Sputtering Recovery Makes China Looks Cheap

China’s May CPI and PPI show disinflation
Those betting on China’s economic rebound (ourselves included) will certainly have been disappointed with the last few months’ data showing a recovery losing steam. Weakness in the country’s growth was reflected further in May’s CPI and PPI reports, both of which show an economy in disinflation. According to China’s National Bureau of Statistics, May consumer prices rose just 0.2% year-over-year, while producer prices hit a 7-year low, plummeting 4.6% year-over-year. Digging deeper into China’s CPI, one finds more evidence of a lopsided recovery, with services inflation rising 0.9% year-over-year—a sign of households’ pent-up demand for leisure and hospitality unleashed after zero-COVID—while goods inflation fell by 0.3% year-over-year, as consumers aren’t yet confident enough to put money down on big-ticket purchases. On the producer side, upstream inputs like mining and raw materials saw the most pain, as weak domestic consumption and prospects for a global downturn continue to weigh on demand, while China’s history of encouraging fixed asset investment in the sector have resulted in too much production capacity.


Low China sentiment makes for attractive valuations
Of course, such bad news on China’s macro picture doesn’t tell us too much at this point we didn’t already know. It’s been well understood since at least March that the nation’s zero-COVID exit recovery has yet to become self-sustaining. Like many others, we had higher hopes for China’s rebound in the months before it abandoned harsh pandemic protection measures. Earlier last year, we noted that East Asian emerging economies’ valuations had become relatively attractive, having sold off well before their developed markets counterparts as Fed policy turned hawkish. While valuations in Taiwan and South Korea have rebounded sharply, China’s mainland equities have languished (see below).

Figure 3 China's Emerging Neighbors Winning

As contrarian value investors, we often find the greatest opportunities arise for assets in which most other investors have entirely lost faith. China fits the bill in that respect, as both foreign and domestic sentiment toward its stock market approach a level at which most of the bad news—both geopolitical and macroeconomic—is priced in. That creates an asymmetric possibility of upside surprises.


Fiscal support the most likely catalyst
What could catalyze a new rally in Chinese shares? Monetary policy will obviously be part of the story, and we’re already seeing token easing, with the People’s Bank of China (PBOC) making a 10 bps cut last Thursday to its medium-term loan facility (MLF), the first such action in 10 months. While we expect more of these liquidity injections in coming months, it can’t be the solution to China’s problems; the availability of cheap money means nothing if consumers have no confidence to spend and businesses in the private sector lack the confidence to invest. Instead, we believe the ultimate spark for a recovery in Chinese stocks will be more significant announcements on the fiscal front. We’re already seeing smaller-scale targeted stimulus—with respect to clean energy and EVs, for example—but wouldn’t rule out news of broader programs to boost consumption rolled out after a Politburo meeting in July.