The Fed Needs to Be the Adult in the Economy Alongside full employment and stable prices, the Federal Reserve has another, lesser known mandate: to be the adult in the economy, writes Greg Ip. That’s especially true at times like now when events are whipsawed by unpredictable actors at home and abroad.

(…) stripping out volatile components such as inventories and trade, Macroeconomic Advisers estimates private demand growth picked up to 1.8% in the current quarter, close to the 1.9% which the Fed considers the long-run trend growth rate for the U.S. economy. Similarly, private payroll growth in May at 90,000 jobs is around the long-run trend consistent with the country’s aging population. So the economy could simply be slowing from an abnormal 3% pace of growth to a normal 2%, which is what the Fed expected when it began raising rates.

If growth is headed to below 1.9% or negative territory, that’s a reason to cut rates, a lot. The probability of recession in any given 12-month stretch is usually 17%. It’s now 42% based on economic data, and 60% based on the yield curve, according to JPMorgan Chase .That’s too high for comfort. Yet other than the yield curve, there are few warning signs of recession. This gives the Fed reason to signal a readiness to cut, but not necessarily this instant.

Stripping out food and energy it was just 1.6% in April, well below the Fed’s 2% target. (…) The Federal Reserve Bank of Dallas’ “trimmed mean” inflation gauge, which jettisons components that are weirdly high or low, is right at 2%. (…)

Mr. Powell similarly [to Greenspan in 2003 just before the war in Irak] can better judge at the Fed’s July 30-31 meeting whether a full-blown trade war with China is likely and will hammer the U.S. Cutting rates before the Fed can make a clear case with the evidence on hand doesn’t exactly project stability and calm. And the world needs a calm, stable Fed.

If trade risk is grave enough for Mr. Powell to cut rates, either in July or sooner, he will be accused of acquiescing to Mr. Trump’s demands that the Fed support him in his fight with China. He should brush off the accusations. It’s not Mr. Powell’s job to shape trade policy any more than it was Mr. Greenspan’s to prescribe military doctrine. The Fed chairman has to accept such policies as given, then act to protect the economy from the fallout. The biggest risk to the Fed’s independence isn’t Mr. Trump but failing at its job.

The big debate:

• Growth has clearly slowed in Q2 but is it mainly because of a temporary inventory realignment or is it the trade war sapping world and American economies?
• Should the FOMC act preemptively or wait and see if things get worse?
• And did it go too far last year given what we now know, particularly given how low inflation seems to be?

Cumberland Advisors’ Robert Eisenbeis does a great job presenting the lay of the economic land:

WHAT DOES “DATA-DEPENDENT” MEAN?

(…) So what now are the key data elements that the Fed will be looking at for its upcoming meeting, and what might available data say about the need for a rate cut, keeping in mind that the FOMC staff had already included a near-term slowdown in the forecasts that were the basis of the “patience” policy stance coming out of the April-May meeting? Clearly, there are some plusses and minuses in the available data.

On the plus side, first-quarter real GDP growth was 3.1%, which is arguably above-trend growth. The unemployment rate is at a 50-year low at 3.6%, and labor markets are strong. New claims for unemployment insurance are running about 225K per week and are not only low by historical standards but also at all-time lows as a percentage of the labor force. Additionally, we continue to have more job vacancies than we have job seekers who are unemployed.  Despite the tight labor market the recently released Manpower survey showed that 27% of the survey respondent planned to add workers in the third quarter, a 13 year high.[3]  The most recent data on productivity, which has been mired in the doldrums for most of the recovery, may finally be showing signs of a rebound, increasing 3.4% in the first quarter of 2019 (compared with a year-over-year increase of 2.4%). Similarly, unit labor costs also decreased, reflecting the increase in productivity without labor cost pressures. Consumer debt increased in the latest report and signals increased spending on the part of consumers.[4] At the same time, small-business optimism is actually up, according to the most recent NFIB survey.[5]

On the negative side, the housing market has softened; manufacturing output has weakened; and durable goods orders are off as well.[6] But the number that has caught everyone’s attention is the weak CES jobs number, which came in at 75K.[7] Not only was the number about 100K below expectations, but the previous two months data were revised down – for March from 189K to 153K, and for April from 263K to 224K, making the totals about 75K less than previously reported. Job gains for 2019 have averaged 164K per month, compared with 223K per month for 2018. But one month’s data doesn’t necessarily signal a trend, and it is risky to focus on a given month’s data. In February only 56K jobs were created, but this low was followed by 153K and 224K the next two months. Similarly, in September 2017 the economy created only 18K jobs, but then it generated 260K jobs in October of that year, 220K in November, and 170–171K the next two months.[8]

What more data will the FOMC have as it contemplates policy for June? We know there will be a new set of SEP forecasts, so those should provide additional insights into how the Committee views the rest of 2019 and whether it thinks near-trend growth is possible. We also know that there is a new Beige Book, and it is useful to see how the information from the districts has or has not played into how the FOMC has characterized the economy recently.

(…) in December 2018, when GDP growth was 2.2% on a year-over-year basis, half the districts reported moderate growth, which typically means about 2.2–2.4%, while all but two of the rest reported modest growth (something less than 2% – slightly less than moderate).[9] The FOMC, however, characterized growth as rising at a solid rate. District estimates for the three meetings in the first quarter of 2019 suggested that economic activity was not as robust, and the FOMC stated that economic activity had slowed somewhat in the first quarter of 2019 as compared with 2.2% growth in Q4 2018. We know, however, that real GDP growth in the first quarter turned out to be a full percentage point stronger, at 3.2%, than it was in Q4 2018. Looking forward to the June meeting, the districts are suggesting that activity was not even as strong as what they saw for Q4 2018. It appears that there may be a disconnect between what the districts are reporting and how the FOMC distills the information at the meeting, even when compared with the actual outcomes.(…)

What is left is a picture of an economy that is growing at trend and one that was already expected by the FOMC to slow somewhat from the 3.2% GDP number for the first quarter. This picture is in line with the forecast discussed in the last meeting minutes. With the labor market still exceedingly tight and financial conditions extremely accommodative, at least as suggested the Chicago Fed’s broad-based National Financial Conditions Index, it seems there is no pressing need for the FOMC to deviate at this time from the policy path the Committee laid out the last time its SEP forecasts were revealed. To move to cut rates now, given the present rather benign economic situation, risks sending an inadvertent message to markets that the Fed sees serious enough concerns ahead that it needs to act pre-emptively, when that may not be the case.

But this “data dependent” Fed pivoted early in 2019 after equity markets sent a strong signal that all was not that “solid”. It again sought to calm markets a few weeks ago hinting at possible rate cuts.

And now we have the inflation debate and the introduction of the 16% trimmed-mean CPI as potentially the better measure, convenient as it is at its current 2.2% reading and 2.0% annualized rate in the past 3 months.

Digging into the CPI data, one can learn more stuff to muddle the debate even more.

The Atlanta Fed’s sticky-price consumer price index (CPI)—a weighted basket of items that change price relatively slowly—rose 2.3 percent (on an annualized basis) in May, following a 2.7 percent increase in April. On a year-over-year basis, the series is up 2.4 percent.

On a core basis (excluding food and energy), the sticky-price index rose 2.2 percent (annualized) in May, and its 12-month percent change was 2.4 percent.

This basket is so sticky, it barely moved from a +0.2% monthly rise since mid-2017. But the Atlanta Fed also has a “flexible CPI”, a weighted basket of items that change price relatively frequently. Good name for a basket that swings so much that nobody can really understand why it goes up or down in any given month. That said, this Flex CPI has declined in each of the last 4 months aggregating a 3.2% annualized deflation rate.

Does that tell us that “flexible demand” is really weak?

The White House says that import tariffs are not having any impact on the consumer. Fake news?

In a market commentary dated May 20, Charles Schwab’s Liz Ann Sonders gave us a peek at Cornerstone Macro’s research:

Cornerstone Macro did a detailed analysis on the impact to inflation of tariffs. It’s believed that the latest tariff hikes will begin to pressure the U.S. Consumer Price Index (CPI) next month; and combined with last year’s tariffs, they estimate peak impact on the CPI in year/year terms will be about 0.25%, likely felt in late-summer (all else equal). The threatened 25% tariffs on the remaining $325 billion of Chinese goods—if implemented all at once—would likely be game-changing for inflation and outlook for consumers. 

That $325 billion basket includes $120 billion of consumer goods vs. only $50 billion in the prior rounds; and would likely boost CPI inflation by an additional 0.8%. (…)

As you can see in the chart below, the 10% tariff on the $200 billion basket of Chinese goods, which went into effect last September, was clearly passed through to consumers. The inflation rate of affected goods swung from -1.5% year/year in 2017 to more than 1.7% year/year in early 2019—contributing about 0.15 percentage points to headline CPI. If anything though, this underestimates the full impact as it does not capture tariffs on intermediate and capital goods, since their effects are more difficult to trace.

Tariff-Targeted Goods InflationSource: Charles Schwab, Cornerstone Macro, as of April 30, 2019. *Includes foods, transportation, appliances, electronics, household equipment & furnishings, apparel & accessories, recreational goods, misc.

Cornerstone expects that the just-implemented additional 15% in tariffs on the $200 billion basket will likely cause another step-up in the inflation rate. Assuming a similar pass-through rate to last year’s, inflation on that tariff basket could accelerate by an additional 4.5 percentage points, contributing 0.2 percentage points to the headline CPI.

Worse would be if the threatened 25% tariffs on the remaining $325 billion of Chinese goods (Phase III) are implemented. The value of goods at stake is 50% larger and encompasses far more consumer goods, as you can see in the chart below. Cornerstone estimates that the inflation hit from the Phase III tariff basket would be about 2.5 times as large as for Phase II, for an additional impact of 0.8% on headline CPI; a true potential game-changer.

Compositions of U.S Imports from China

So, lowflation is really transitory. The impact of tariffs are just around the corner.

Wait, wait!

Nancy Lazar, also at Cornerstone Macro, asserts that “low core inflation is NOT transitory, as tame unit labor costs should push it lower into 2020.”

@csm_research

Wait, wait!

Currency adjustments are another factor to consider, as the previous round of tariffs made clear. At present, the United States is imposing a 25% levy on $250 billion worth of Chinese imports. This adds up to a $62.5-billion “tax” on U.S. buyers of these products. In the meantime, though, the renminbi has lost roughly 10% of its value against the USD since January 2018, when Washington first slapped tariffs on solar panels from the Middle Kingdom. Given that goods imports from China totaled roughly $540 billion in 2018, this devaluation should chop about $55 billion off what U.S. importers pay every year, if it persists. In other words, a cheaper renminbi has offset the effect of the tariffs. (…) (NBF)

China is not debating much, they seem to be preparing for something bad. Liu He is the one who supposedly made “the deal” with Lighthizer before Xi killed it.

Chinese vice premier urges more support for economy amid trade war Chinese regulators should step up support for the economy and keep ample liquidity in the financial system, Vice Premier Liu He said on Thursday, suggesting Beijing would soon unveil more policies to bolster growth amid rising U.S. trade pressure.

(…) “At present, we do have some external pressures, but those external pressures will help us boost our self-reliance in innovation and accelerate the pace of high-speed development,” said Liu.

The government will announce more strong measures to promote reforms and opening up of its markets, added Liu. (…)

Earlier on Thursday, China Daily, citing economists, said China is expected to adjust money and credit supply in coming weeks, including cuts to interest rates or reserve ratio requirements, to counter risks if the trade outlook deteriorates.

The commerce ministry said on Thursday Beijing will not yield to any “maximum pressure” from Washington, and any attempt by the United States to force China into accepting a trade deal will fail. (…)

• Trump Says His China Deadline Is ‘Up Here,’ Pointing to His Head

“I have no deadline,” Trump told reporters at a news conference Wednesday at the White House. “My deadline is what’s up here,” he added, pointing to his head. (…)

Trump said Tuesday he’s personally holding up a deal and won’t complete an agreement unless Beijing returns to terms negotiated earlier in the year. A day earlier, he threatened to raise tariffs if President Xi Jinping doesn’t meet with him at the upcoming Group of 20 summit in Japan.

“I would never take something that would be less than what we already had,” Trump said, noting an agreement to prevent intellectual property theft. “I think we’ll end up making a deal with China. We have a very good relationship, although it’s a little bit testy right now, as you would expect.” (…)

“We’ll figure out the deadline,” Trump said Wednesday. “Nobody can quite figure it out.”

That last part is quite true.

However, the other side of the equation seems to have a different deadline in its head:

• Tour of China Shows a Nation Girding for Protracted Trade War

(…) 10 days of meetings with Chinese officials, academics, entrepreneurs and venture capitalists revealed a nation rewriting its relationship with the U.S. and preparing to ride out a trade war. (…)

Informing part of the decision to move on is the Chinese view of Trump as an erratic partner after four months of negotiations over a broad trade agreement broke down in May. U.S. officials blamed China for reneging on commitments; the Chinese blamed Trump’s ever-changing demands. That view has been bolstered by Trump’s retreat last week on his threat of tariffs as high as 25% on Mexico — even after negotiating an updated North American Free Trade Agreement that enshrined tariff-free trade.

On either side of the Pacific, there are fundamentally different conceptions of who has leverage. (…)

Huawei’s Booming Smartphone Business Dealt Blow by U.S. Ban The recent U.S. move to blacklist Huawei Technologies threatens to cut off its access to crucial phone components and software for devices used by millions of people world-wide.

(…) For example, it was revealed last week that Huawei phones would no longer be sold pre-installed with FacebookInc. apps, including Instagram and WhatsApp.

That follows the loss of licenses to use Google’s Android operating system for new Huawei phone models, which led some Japanese and European carriers to drop plans to launch such phones. The Chinese government is pressuring large U.S. technology companies to avoid aggressively acting on the U.S. trade restrictions. (…)

JPMorgan analysts cut their forecast for Huawei’s overseas smartphone shipments by 30% to 90 million units for the year because of the Android disruption. (…) Wayne Lam, a smartphone analyst at research firm IHS Markit ,said Huawei could lose about half of its European market share if it’s unable to license new software and services from Google. (…)

• Huawei asks Verizon to pay over US$1-billion for over 230 patents: source

(…) The patents cover network equipment for more than 20 of the company’s vendors including major U.S. tech firms but those vendors would indemnify Verizon, the person said. (…)

Apple’s U.S. iPhones Can All Be Made Outside of China If Needed

The Cupertino, Calif.-based company’s primary manufacturing partner has enough capacity to make all iPhones bound for the U.S. outside of China if necessary, according to a senior executive at Hon Hai Precision Industry Co. [Foxconn]. The Taiwanese contract manufacturer now makes most of the smartphones in the Chinese mainland. (…)

“Twenty-five percent of our production capacity is outside of China and we can help Apple respond to its needs in the U.S. market,” said Liu, adding that investments are now being made in India for Apple. “We have enough capacity to meet Apple’s demand.” (…)

The trade war has disrupted a complex global supply chain involving many countries beyond just China and the U.S. Many components that go into devices aren’t made in the U.S., despite being designed there. A phone chip designed by Apple may come out of a factory in Taiwan, then be packaged (a process that prepares it for integration into a circuit) somewhere else, before being shipped to China for assembly into an iPhone.

“It would be relatively easy to shift final assembly of the iPhone outside China, but moving to full production of the components and the whole handset would be much tougher,” Mawston said. (…)

 Trump Threatens Merkel With Pipeline Sanctions, U.S. Troop Cut

(…) Echoing previous threats about German support for the Nord Stream 2 pipeline, Trump said he’s looking at sanctions to block the project he’s warned would leave Berlin “captive” to Moscow. The U.S. also hopes to export its own liquefied natural gas to Germany. (…)

Meanwhile, in the real world:

While tariffs no doubt contributed to the 12.8% y/y drop in imports from China in the first four months of the year, retaliatory measures by Beijing have hurt U.S. exporters as well. Indeed, U.S. exports to China were down no less than 20.9% year to date compared with their level a year ago. Total trade between the two countries (exports + imports), meanwhile, dropped 14.5% over the same period. This collapse in two-way trade between the two countries also explains why the overall goods trade between the United States and the world has stalled in the past 12 months.

What’s more, while the U.S. goods trade deficit with China has shrunk 9.9% y/y in the first four months of 2019, the deficit with the rest of the world has ballooned 8.5%. This suggests that Chinese imports are being replaced with foreign and likely more expensive alternatives, not domestic goods produced in U.S. factories. (NBF)

Euro zone industry output drops again, dragged down by Germany

European Union statistics office Eurostat said output in the 19 countries sharing the euro dropped by 0.5% on the month, in line with market expectations, and by 0.4% year-on-year. The monthly fall in April followed a 0.4% decrease of the industrial production in March and a flat reading for February. (…)

Germany, the euro zone’s largest economy, suffered a 2.3% drop, while output in Italy, the zone’s third largest economy, declined for a second straight month, by 0.7%. Production in France, the number two economy, rose by 0.4%.

U.S. Global Investors

Duke’s Fuqua School of Business / CFO Magazine Global Business Outlook

Results for 238 U.S. firms (own-firm changes expected during the next 12 months):

Nearly half (48.1%) of US CFOs believe that the US will be in recession by the 2nd quarter of 2020 and 69% believe that a recession will have begun by the end of 2020. CFOs are even more pessimistic in most other regions of the world:

If you are one of these pessimistic CFOs, you prepare now: cut costs, prune capex and reduce debt.

Imports at Southern California Ports Fell Sharply Last Month Drop ahead of peak shipping season came as a retail industry group cut its forecast for import growth in the coming months

Combined inbound loaded containers at the ports of Los Angeles and Long Beach, the neighboring ports that comprise the largest U.S. gateway for seaborne trade, fell 6.3% last month from a year ago. The ports handled 48,256 fewer loaded import containers than they did in the same month last year.

Combined exports at the two ports also fell 7.4%.

The decline, in a month when maritime operators usually are gearing up for the year’s peak seasonal shipping volumes, suggested that importers are pausing orders for goods after accelerating imports for several months to get ahead of rising tariffs launched by Washington and Beijing. (…)

Peter Sand, chief shipping analyst at Bimco, an organization representing shipowners, said in a report Wednesday that container shipping demand world-wide has been softening this year and grew by 0.5% in the first quarter from a year ago, sharply below average growth rates over recent years. Volumes for intra-Asia trade also declined 0.2% in the first three months of the year, which Mr. Sand is a troubling signal for broader trade demand later this year.

“The drop is a sign of weakening volumes in the supply chains and, ultimately, the result of fewer new export orders received by Asian manufactures in recent months,” Mr. Sand said, “something that will impact outbound volumes in the coming months.”

U.S. Budget Deficit Grew 39% in First Eight Months of Fiscal Year Government tax revenue continued to rise in May thanks to a sturdy labor market, but not enough to offset higher federal outlays, the Treasury Department said.

(…) The government ran a $739 billion deficit from October through May, compared with $532 billion during the same period a year earlier, the Treasury said.

Federal outlays rose 9%, to $3 trillion, reflecting higher spending on federal retirement and health benefits, the military and interest on the debt. Receipts increased 2%, to $2.3 trillion, as job gains and rising wages contributed to higher individual income tax revenue, offsetting a decline in corporate income tax receipts following the 2017 tax law overhaul. Revenue growth has lagged economic output, which increased 4.9% in the first quarter from a year earlier, not adjusted for inflation.

About half of the increase in the deficit was due to a shift in the timing of certain federal payments, which made the deficit appear larger, the Treasury said. If not for those calendar quirks, the deficit would have risen just 19% in the first eight months of fiscal 2019, which started Oct. 1. (…)

For the 12 months ended in May, the deficit totaled $985.3 billion, or 4.7% as a share of gross domestic product, the highest since May 2013. (…)

Higher tariffs imposed by the Trump administration over the past year have also contributed to higher government revenues. The Treasury said Wednesday it collected $46 billion in customs duties from October through May, an 80% increase compared with the same period a year earlier.

President Trump in May increased tariffs on $200 billion of Chinese goods to 25% after negotiations over a new trade deal broke down. The Treasury last month collected $5 billion in customs duties, compared with $3 billion in May 2018. (…)

Falling Mortgage Rates Spur Application Frenzy Rates for 30-year fixed mortgages have fallen below 4% in recent weeks for the first time since 2017

The volume of mortgage applications surged by 27% last week, the biggest weekly rise in more than four years, according to a survey released Wednesday by the Mortgage Bankers Association. (…) Some 6.8 million borrowers stand to save at least 0.75 percentage point on a mortgage by refinancing, according to Black Knight Inc., a mortgage-data and technology firm. (…)

@csm_research