Odysseus And The Sirens

Larry Summers is worried. About good news.

Headline US inflation likely decelerated in July, which, if borne out by crucial data due Wednesday, would represent a welcome reprieve for American households. The optics of cooler prints would also be good for the Fed which, all “long and variable lag” excuses aside, isn’t running fast enough to catch inflation. Maybe hindsight will allow us to say that in fact, the Fed did overtake inflation this summer by setting the stage for a recession that ultimately cooled price growth in a sustainable way. But it’ll be a long time before anyone can make such determinations.

In the meantime, good news could lure the Fed into the rocks. As I put it following July’s rate hike, the second 75bps move in as many meetings, “Fed officials need to bind themselves to the mast in order to avoid falling victim to the siren song of easing prematurely.”

Summers fears Jerome Powell is no Odysseus. “I’m worried we’re going to see some good news on non-core inflation,” Summers told Bloomberg Television’s David Westin, during his latest paid “contribution” to “Wall Street Week,” which Bloomberg pretends is some kind of American institution on par with Happy Days and The Tonight Show. If headline CPI recedes it could “lead the Fed to think that things are under control,” Summers added.

Economists expect a marked deceleration in the monthly headline print, which should show prices rose a mere 0.2% from June (figure below). Core prices, on the other hand, likely rose more than double that, extending a streak of uncomfortably hot sequential readings.

June’s CPI report, you’ll recall, was among the worst in modern American history. If July’s report is “better,” that’ll be a relative term, and the bar to clear is very low (or high, depending on how you want to look at it).

I’d note that commodity prices are down fairly sharply (figure below), and retail gas notched a 50th consecutive daily decline last week. Grain ships are sailing again from some of Ukraine’s ports under a deal brokered by NATO’s favorite autocrat.

Meanwhile, reports of consumers scaling back on necessities, combined with a (controversial) drop in a key proxy of Americans’ thirst for gasoline, suggest the economy is in the early innings of demand destruction. So, there’s certainly scope for headline inflation to cool materially.

On the other hand, waiting for headline inflation prints to roll over is a frustrating experience in 2022. And now markets are looking for a full percentage point drop in the MoM headline print. Even if that materializes, inflation long ago broadened into so-called “sticky” categories, and the read-through of lower gas prices is just more spending on discretionary items, at cross purposes with the Fed’s inflation-fighting efforts.

“Higher necessity costs have acted as a tax on consumption, so it follows intuitively that as costs at the pump begin to moderate, disposable income will be freed up elsewhere to drive spending (and prices) in other categories,” BMO’s Ian Lyngen and Ben Jeffery said. “As such, core CPI is seen increasing +0.5% in July, leading the yearly pace to move up to 6.1% from 5.9% — not the 6.5% peak core prices saw in March 2022, but unquestionably trending in the wrong direction from the Fed’s perspective.”

The other issue is wages. The July jobs report was a veritable barnburner and the accompanying wage data didn’t do much to dispel fears of a wage-price spiral. Two-year yields posted among their largest one-week gains in a dozen years, extending a volatile stretch (figure below) and unwinding the rally triggered by a misread of Powell’s press conference the prior week.

The 2s10s inversion plumbed ~45bps. If growth concerns deepen, so will the inversion.

“Everything in this number says to me overheating, not yet under control, not yet on a path to being under control,” Summers said, of the jobs report, which Goldman called “indicat[ive] of an overheated labor market that continues to tighten further.” The bank still expects September’s rate hike to be a 50bps increment, though. Goldman sees 100bps of additional hikes by year-end — 50bps in September and 25s in both November and December. That said, the bank acknowledged that the “risks [are] skewed towards earlier or larger increases.”

Speaking of that, Bloomberg’s Alyce Andres said investors “might want to start thinking about an inter-meeting rate hike.” She called the average hourly earnings figures that accompanied the jobs report “the real shocker.” “Wages are a proxy for core inflation,” she remarked. “Hiking off-schedule might not have been the way the Fed wanted to start its tightening cycle [but] with a handful of hikes under its belt and inflation spiraling, it might not feel so out of place.”

If July’s CPI report comes in hotter than forecasts, it wouldn’t be terribly surprising to see markets start to price an inter-meeting move. After all, the Fed will get another jobs report and another CPI report prior to September’s meeting. I doubt the Committee would be excited about the prospect of consecutive scorchers on both fronts, as that’d likely put the 100bps discussion back on the table for the September gathering. Powell could use Jackson Hole to editorialize around any inter-meeting move, although I imagine he’d hold a press conference if the Fed hiked before the September meeting. Hiking 75bps preemptively and canceling the September FOMC isn’t an option — it’s an SEP meeting. The figure (below) shows Fed pricing post-payrolls.

Officials worked overtime last week to dispense with the dovish pivot canard. Over the weekend, Michelle Bowman said she sees few, if any, signs that inflation has peaked.  She wants “unambiguous” evidence that inflation is receding before the Fed changes its outlook, and said she backs hiking rates until inflation is on a “significant” decline. Traders will hear from Evans, Kashkari and Daly this week.

“We think [July’s jobs] report supports the view that the Fed is not close to being done on the rate hiking cycle and much less close to ‘pivoting’ on policy,” TD’s Oscar Munoz and Gennadiy Goldberg remarked. “The report is likely to enhance the Fed’s inclination to front-load rate hikes until the policy rate overshoots neutral by a good margin over the next few months.” Goldberg took profits on a Jan 23 Fed funds short after terminal rate pricing moved back up to 3.60% after receding near 3.20%.

Also on deck this week: NFIB (which will likely reflect another month of very poor small business sentiment), PPI, the first read on University of Michigan sentiment for August (with accompanying inflation expectations prints) as well as second quarter productivity and unit labor cost data, which could be noteworthy under the circumstances.

SocGen’s Subadra Rajappa captured the rates zeitgeist well. “The ‘data dependence’ rollercoaster is fully operational,” she said, calling the situation “rudderless.”