‘Forthright’ Federal Reserve set to stick with 75bp rate hike
Federal Reserve Chair Jerome Powell’s comments to the Cato institute’s conference today on monetary policy are clearly supportive of a third consecutive 75bp interest rate hike on 21 September. There is no hint that he supports moderation, arguing that “we need to act now, forthrightly, strongly as we have been doing and we have to keep at it until the job is done”. There is also the usual mention of inflation expectations and the need to anchor them in order to ensure inflation doesn’t become ingrained.
The latest data certainly backs the case for 75bp with business surveys looking robust, the labour market continuing to create jobs in significant numbers, and next week’s inflation numbers set to show core CPI accelerating to 6.1% from 5.9%. Moreover, the third quarter is shaping up to be quite a strong one, fully reversing the declines seen in GDP in the first half of the year.
Meanwhile, consumer spending is being boosted by the lift in spending power from lower gasoline prices. High-frequency data over the Labor Day holiday show restaurant dining at record levels, while air passenger travel over the past weekend exceeded that of 2019 for the first time, so 3% growth looks to be on the cards.
High-frequency data point to strong 3Q consumer spending
Although broader stats point to slow spending, particularly when factoring in inflation:
And Bleakley Financial Group’s CIO Peter Boockvar notes that
Newell Brands, which makes everything from Sharpie pens, Elmer’s glue, and Rubbermaid garbage cans, to Graco baby products, Yankee Candles, Coleman camping equipment and Mr. Coffee machines said this last night in their lowered guidance, ‘Although we remain enthusiastic about the back-to-school season and continue to see solid growth in the Commercial business, we have experienced a significantly greater than expected pullback in retailer orders and continued inflationary pressures on the consumer.’ What speaks to me is the compression in retail orders ahead of the key holiday season.
Mr. Powell said the key lesson from the high inflation of the 1970s and the aggressive steps taken by Fed Chairman Paul Volcker in the early 1980s to bring inflation down was the importance of preventing households and businesses from expecting inflation to rise.
The takeaway for policy makers, he added, is that “the longer inflation remains well above target, the greater the risk the public does begin to see higher inflation as the norm and that has the capacity to really raise the costs of getting inflation down.”
U.S. Jobless Claims Fall for Fourth Straight Week New filings for unemployment benefits remain historically low in a tight labor market
This chart shows unemployment claims with the scale set to reflect levels between 2014 and 2019. The horizontal line is the average for that period. The low in claims was in March.
Inflation and the Scariest Economics Paper of 2022 To bring price increases down to 2%, we may need to tolerate unemployment of 6.5% for two years.
By Jason Furman, a professor of the practice of economic policy at Harvard University, was chairman of the White House Council of Economic Advisers, 2013-17.
The scariest economics paper of 2022 argues that labor markets remain extremely tight, underlying inflation is high and possibly rising, and several years of very high unemployment may be necessary to get inflation under control. The paper is a painstaking empirical exploration by Johns Hopkins macroeconomist Larry Ball with co-authors Daniel Leigh and Prachi Mishra of the International Monetary Fund released by the Brookings Papers on Economic Activity. It shows why the Federal Reserve will likely need to maintain its war on inflation, even if unemployment continues to rise.
Economists use labor market slack to help predict inflation. Typically they look at the unemployment rate, but using the ratio of job openings to unemployment to measure labor market slack offers a clearer picture. Analysts who focused solely on the unemployment rate mistakenly believed the labor market still had substantial slack in 2021 and deemed wage and price inflation transitory. The big burst of inflation that followed left them scratching their heads. Messrs. Ball, Leigh and Mishra find that labor-market tightness itself added 3.4 percentage points to underlying inflation in July 2022.
The paper also argues, convincingly in my view, for a different measure of underlying inflation. Fluctuations in energy and food prices are generally due to factors outside the control of macroeconomic policy makers. Geopolitics and weather have elevated the inflation rate in recent years. Plunging gasoline prices are temporarily lowering the inflation rate now. That’s why economists since the 1970s have focused on “core” inflation, which excludes food and energy.
But food and energy aren’t the only things people buy that are subject to supply-side volatility. Prices of new and used cars, for example, have gyrated over the past two years for reasons that are mostly unrelated to the strength of the overall economy. Both regular and core inflation are based on taking averages of price increases and can be distorted by large changes in outlier categories. The median inflation rate calculated by the Federal Reserve Bank of Cleveland drops outliers to remove these distortions.
Median inflation is a statistically better measure of the underlying inflation that policy makers can actually control. This is worrying because while the Fed’s preferred headline inflation fell to zero in July and annual inflation excluding food and energy has stabilized at around a 4% annual rate, median personal-consumption expenditure inflation shows no sign of moderating and has run at a 6.6% annual rate in the last three months.
The scariest part of the new paper, however, is when the authors use their model to forecast the unemployment rate that would be needed to bring inflation down to the Fed’s 2% target. The authors present a range of scenarios, so I ran their model using my own assumptions. I assumed that the labor market will cool on its own as job openings fall two-thirds of the way back to what they were before Covid. I also assumed that inflation expectations will fall back toward where they were before Covid and that the recent good news on gasoline and other volatile prices will keep coming for the rest of 2022.
Under these assumptions, which are more optimistic than the authors’ midpoint scenario, if the unemployment rate follows the Federal Open Market Committee’s median economic projection from June that the unemployment will rise to only 4.1%, then the inflation rate will still be about 4% at the end of 2025. To get the inflation rate to the Fed’s target of 2% by then would require an average unemployment rate of about 6.5% in 2023 and 2024.
There is, of course, tremendous uncertainty with this forecast. If businesses believe that low inflation is coming and act like it, inflation could fall without a large increase in unemployment. On the other hand, if the labor market doesn’t shift back to the way it was working pre-Covid, or if there are more unfavorable supply shocks, the outlook could be more painful.
What should the Fed do? Four things: First, place more emphasis on the ratio of job openings to unemployment and median inflation as it assesses the tightness of labor markets and the underlying rate of inflation. Second, the new paper shows how much easier it will be to tackle inflation if expectations remain under control. The Fed should follow up on Chairman Jerome Powell’s tough talk at Jackson Hole with meaningful action such as a 75-basis-point increase at the next meeting. Third, be prepared to accept the unemployment rate rising above 5% if inflation is still out of control. Finally, stabilizing at a 3% inflation rate is probably healthier for the economy than stabilizing at 2%—so while fighting inflation should be the central bank’s only focus today, at some point the Fed should reassess the meaning of victory in that struggle.
There is clearly a need to improve the measurement of labor tightness. But simply using job openings is too simple.
The growth in remote work incites employers to announce openings in multiple locations, creating multiple “openings” for a single job. With technology and social media, a company such as Google can easily post a job offer in all 50 states, and in Canada, or anywhere in the world actually.
This year, one of our sons hired over 100 engineers/coders across the world without any measurable postings; word of mouth and references did the job.
At the other end of the skill spectrum, convenience store operator Circle K, struggling to find/keep employees in recent years, was surprised to get 120k applications for its 20k job openings in August.
It is becoming increasingly challenging to measure both labor demand and labor supply. For now, the focus should be on the resulting data:
- While goodsflation is slowing much, wageflation is not:
- Services inflation, 60% of the CPI and intimately tied to wages and energy, remains the key. July showed a nice slowdown but we had a similar “lull” last summer that did not last
- BTW: Wholesale Used-Vehicle Prices Decline Substantially in August Wholesale used-vehicle prices (on a mix, mileage, and seasonally adjusted basis) decreased 4.0% in August from July. The Manheim Used Vehicle Value Index declined to 210.8 but is up 8.4% from a year ago.
Biden Team Weighs New Oil Release Among Steps to Rein In Prices
The European Central Bank Goes Big on a Rate Hike A three-quarter-point rate increase, but no quantitative tightening.
(…) But notably missing from Thursday’s announcement was an indication of when the ECB might start shrinking its balance sheet by running off maturing government and other bonds it has bought under its two quantitative-easing programs. The closest Ms. Lagarde will come is to repeat that maturing principal in the more recent of the two, the Pandemic Emergency Purchase Program, will stay on the books at least until the end of 2024. There’s no timeline for paring back bonds acquired under the original Asset Purchase Program.
The main reason for the delay on quantitative tightening appears to be concern that government borrowing rates would go haywire if the ECB removes this support. Ms. Lagarde plans to create a new mechanism to subsidize debt from euro members such as Italy to avoid this, but for now the ECB is reinvesting maturing principal from the pandemic QE program “flexibly,” which is code for diverting most of that cash to purchases of new Italian debt. The ECB seems afraid of what might happen if markets are able to price eurozone risks again. (…)
Inflation Eases in China as Growth Challenges Pile Up Consumer prices rose just 2.5% in August from a year earlier, slower than in the previous month and short of expectations
(…) The unexpected slowdown in consumer prices was driven primarily by prices for food, as well as falling fuel prices. The government took steps to boost the supply of pork by releasing stocks from its reserves, easing what has been a sharp run-up in pork prices. Prices for fruit and vegetables also rose less than expected.
(…) Producer-price inflation, a gauge of factory-gate prices charged by Chinese manufacturers, slowed to 2.3% in August from 4.2% in July, according to the data released Friday. That was the weakest reading since February 2021 and the 10th straight month of slowing price growth. (…)
Core CPI inflation was flat (+0.8% YoY), and inflation in services was also flat (+0.7% YoY).
(@C_Barraud)
Real (estate) gangrene:
Chinese Banks Lose a Mortgage Safety Net as Developers Slide Into Distress Real-estate firms have written at least $300 billion in mortgage guarantees on uncompleted homes that they presold
China is increasingly counting on its banks to step up mortgage lending and help boost a sinking housing market. But there is a problem: Lenders are stuck with many mortgages from boom times that are at higher risk of not being repaid.
Chinese property developers wrote at least $300 billion of mortgage guarantees over the past few years for partially built apartments that they presold, according to regulatory filings. The real-estate firms promised that they would cover home buyers’ interest and principal payments to banks if the borrowers defaulted before their apartments were completed and delivered.
What used to be seen as a no-lose proposition has now become a drag on Chinese banks. Dozens of real-estate firms have slid into financial distress, making their mortgage guarantees far from certain. Many would-be home buyers no longer want to buy unfinished properties, reducing demand for loans. (…)
Around 80% of new-home sales in the country over the past decade were of partially built homes that developers promised to deliver in one to three years. Buyers typically put down 30% of a property’s purchase price as a down payment, borrowed the other 70% and started making mortgage payments immediately. (…)
Because the mortgages weren’t collateralized by finished homes at the outset, Chinese developers provided guarantees to banks that stated they would pay the loan interest and principal if individual borrowers defaulted while building was in progress. Many real-estate firms described this as industry practice in their regulatory filings and said they were unlikely to incur any actual financial obligations. (…)
Loosely implemented regulations on escrow accounts in China, however, enabled Chinese developers to withdraw cash before buildings were completed and use the money to fund other activities. (…)
There is a real risk that some housing developments might be left unfinished because the industry downturn has left some developers significantly short of cash. In a worst-case scenario, around 50% of distressed developers’ projects could be halted or delayed and some 6.4% of China’s mortgages—equivalent to around $348 billion in loans—could be at risk of default, S&P Global Ratings estimated in a July report. (…)
China is lucky not to have to hike interest rates to fight inflation…
- The yuan has weakened by as much as 10% against the dollar over the last six months and on Thursday was hovering around 6.96 per U.S. dollar (though it strengthened a bit Friday to about 6.92). Unlike the U.S. dollar, which floats freely in the market without day-to-day interventions from the government, China’s exchange rate is determined by a “managed float” system. Currency analysts at JPMorgan and Bank of America expect the yuan to pass 7-per-dollar soon, and say it’s a sign that China’s policymakers are growing more worried about the malaise of their economy. (Axios)
SENTIMENT WATCH
Institutions buy record bets on a crash
In February 2021, small speculators were going bananas. At the time, I showed what was perhaps the most remarkable chart that I’d seen in my entire career.
Until now.
This time, it’s not small options traders that have panicked. And it’s not FOMO that’s causing it. Rather, it’s the largest traders in the market, and they’re buying protection against a crash at a pace unlike anything the market has ever seen.
Last week, traders of fifty or more contracts bought to open nearly five million put options. More importantly, they spent a whopping $8.1 billion on those contracts. That is almost double the amount of any other week in 22 years. (…)
[The chart] reflects the net dollar value of premiums that institutional traders spent on buying calls to open minus buying puts to open. The lower the blue line, the more they spent on puts.
There has never been anything like this in the history of the data. Whenever we see something like this, the first thought is, “Well, maybe it’s a data error.” And maybe it is. But this is official data reported across all U.S. exchanges, and in the decades we’ve been following it, there has never been a data error.
If we look at the total amount of money institutions spent on bullish strategies (buying calls and selling puts) minus bearish ones (buying puts and selling calls), it’s also at a record spread. They spent $1.6 billion more on bearish strategies than bullish ones. The prior records were $1.1 billion during the week of November 7, 2008 (global financial crisis, Obama victory), and $970 million the week of September 30, 2016 (Deutsche Bank crisis). (…)
It’s not just the options market that is showing heavy bearish bets. Large speculators in S&P 500 e-mini futures have established their largest short position in a decade. As a percentage of open interest, it’s among the largest ever.
The sudden and massive hedging activity of some of the market’s largest traders is unsettling. They have sometimes shown an uncanny ability to buy or sell ahead of significant events in a very short time frame. But the data is too limited to suggest that something is necessarily coming down the pike in the next week or two. More compelling evidence suggests the record put buying is a sign of panic, which has a good track record of preceding rising stock prices over the medium- to long-term.
- S&P 500 Large Cap Index – 13/34–Week EMA Trend Chart
(CMG Wealth)
- Investors are fleeing US equities as the likelihood of an economic downturn rises, BofA said. Stock funds had outflows of $10.9 billion in the week to Sept. 7, the firm said, citing EPFR Global data. The biggest exodus in 11 weeks was led by withdrawals of $1.8 billion from tech stocks. More than $6 billion poured into sovereign debt. (Bloomberg)
Jianzhi Education Technology Group (ticker: JZ) debuted on the Nasdaq Aug. 26 at $126 and traded as high as $186, briefly valuing the outfit north of $11 billion. Less than a fortnight later, JZ settled at $3.99. Earlier in August, investors rolled out the red carpet for the IPO of Hong Kong-based Magic Empire Global Ltd., (ticker: MEGL). After pricing at $4, shares opened at $50 and quickly zipped to $236 to confer a short-lived $4.7 billion market capitalization on the advisory and underwriting firm. The stock now changes hands at $5.11. (ADG)