The Price Problem
After the rate hike, here’s my forecast for Fed action — and my analysis of the Fed’s limits and what more hikes could mean for the economy.
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None of us were surprised. Still, somewhat, Fed Chair Kevin Warsh’s address in late August from Jackson Hole, Wyoming, did two things. One, Warsh signaled financial markets well ahead of Wednesday afternoon’s decision on how he viewed the short-to-medium-term trajectory for monetary policy. Two, with that speech, he really left himself with almost no wiggle room. This readership is aware of how I view the current economic environment. This readership knows that I think that increasing borrowing costs right now would hurt demand for labor and slow economic activity more so than it actually slows this kind of inflation.
That said, Kevin Warsh, who we already know from his time at the Fed more than a decade ago, is naturally hawkish as an economist and as a policy maker. Warsh, after that speech, would have lost credibility had the FOMC not done what it did yesterday. In the dot plot, the committee indicated that this would be no “one and done” rate hike. The median expectation is for one more quarter-percentage point hike in 2026.
My expectation would be that the Federal Open Market Committee takes a powder on Oct. 28 due to the chronological proximity of the midterm elections on Nov. 3. That leaves Dec. 9, in my opinion, as the likeliest date for a short-term boost to the overnight Fed Funds Rate. Futures markets trading in Chicago are currently pricing in a 53% probability for a quarter-point hike on Oct. 28 but an 89% probability for that rate hike to simply be implemented by Dec. 9. On that note, those same markets appear to be pricing in (56% likelihood) a total of an additional three-quarter point rate hike by April of 2027.
Would that be enough to slow consumer-level inflation? Let me put it this way. Yes. Why? Simple. Because it will also weaken demand for labor and capital spending. Small businesses will borrow less, will hire less and will not expand. Workers will remain on the sidelines longer and some will be offered less hours per week while others are laid off outright. Folks making less money will spend less. Businesses with less access to credit will spend less.
So, yes, as aggregate demand slows, economic activity will drag. This will slow the pace of inflation. What rate cuts won’t do is reopen the Strait of Hormuz or make Iran play nice with the rest of the world. This will not alleviate the rising costs associated with the transit of either people or cargo. As I have said, should this be the start of a serious tightening cycle, concerning monetary policy, it will end in crisis.
We know this because we have been around the block more than once. We do know that there is a Phillips Curve. We do know that though the concept was beyond Janet Yellen’s depth that there is an inverse relationship between inflation and unemployment. That is exactly what Warsh is counting on as he sees this economy is stronger than I do. I also see supply shocks such as we have now, as impervious to anything but extreme changes to monetary policy. That is the realm of foreign policy and diplomacy. That will require increasing the roles of either politicians or soldiers. That is not work cut out for economists.
On That Note…
Retail sales were apparently outstanding in August. Or were they? On Wednesday morning, the Census Bureau posted its results for August retail sales. At the headline, these sales grew 1.2% on a month-over-month basis up from -0.5% in July. At the core (ex-autos and parts), these sales increased 1.4% m/m, up from -0.2% in July. Those results blew away the consensus view, which was for growth of 0.7% and 0.5% respectively.
There was strength in sales of electronics, appliances, sporting goods, musical instruments and books as “back to school” shoppers took the stage. Gasoline sales were the big item though at +3.1% m/m. What did not keep up? Building materials, which is important because it also implies growth in demand for labor. Department stores did not keep up, which is odd for the back-to-school season and likely means that consumers were fishing for discounts online. Grocery store sales also failed to keep up. I don’t like that.
It’s important to remember that the Census Bureau reports retail sales in nominal U.S. dollars. These numbers are not adjusted for inflation. What does that mean, simply put? It means that while August retail sales were hot, they were not “that” hot. Core retail sales were up 4.9% year over year for August. The August consumer price index was up 3.4%. Well, simply put that means that retail sales had to grow 3.4% just to break even, so there is growth. Let’s just keep our heads about us. Core retail sales were only up 4.1% year over year for July, a month with no “back to school” push.
Marketplace
Most readers already know that markets are showing some resilience overnight. The U.S. Ten-Year Note pays 4.99% this morning after kissing 5.03% late Wednesday. The more Fed-sensitive Two-Year Note yields 4.72% this morning after paying more than 4.74% last night. The super rate sensitive Three-Month T-Bill has not seen that yield come in this morning. That item, which is key to those holding cash, now pays 4.08%.
On the bright side, front-month WTI Crude is trading with a $101 handle (per barrel) down from $106 on Tuesday. That, and the slight rally flattening of the slope of the Treasury yield curve is putting an overnight bid under stocks. U.S. equity index futures have been strong overnight, which might surprise a few folks.
On Tuesday, mostly after Fed Chair Kevin Warsh held his press conference, U.S. equities sold off rather sharply around the edges. The broader indexes were not pelted. The S&P 500 gave up 0.45% as the Nasdaq Composite gave back just a smidgen. For both of these indexes, though, Wednesday was a third consecutive day in the red and a seventh red candle session in eight. The Dow Transports were taken out to the woodshed for a loss of 2.76%, thanks to a 13.3% beatdown suffered by trucking giant JB Hunt (JBHT). All the truckers followed suit. That’s what higher fuel costs are doing at the producer level.
Pop Quiz
Question: Wouldn’t higher interest rates be good for the banks?
Answer 1: Not if fewer businesses and households can afford to borrow.
Answer 2: Not if the longer end of the curve doesn’t play ball with the short end. Higher short-term rates coupled with lower long-term rates only compresses net interest margin which is the primary vehicle for profitability among traditional bankers.
Breadth
Marketwide breadth on Wednesday was not nearly as bad as folks probably think. That’s because the fear factory on the financial networks was in full effect as sensationalism outweighed common sense in an attempt to garner ratings. Eight of the 11 S&P sector SPDR ETFs closed out the Wednesday session in the red, led lower by energy (XLE) and the financials (XLF).
Losers beat winners at both the NYSE and the Nasdaq by close to three-to-two margins. Aggregate trading volume across both NYSE and Nasdaq-listings was higher on a day-over-day basis. NYSE-listed trade was up 3%, while Nasdaq-listed trade was up a stunning 25.6%. Does that make Wednesday’s selloff that much more meaningful?
Not really. Check this out. While advancing volume took a less than respectable 39.6% share across composite NYSE-listed activity, advancing volume took an impressive 57.7% share of composite Nasdaq-listed trade. That’s right. On a down day, advancing volume took a decisive share of the action across Nasdaq-listed names. What to make of that? Was Wednesday the necessary pause? Hard to say that as the headline indices traded lower. Did it signal a Thursday morning rally? Looks like it right now. Thursday certainly will be interesting. Final trading volumes will likely tell us a lot.
Economics (All Times Eastern)
08:30 – Initial Jobless Claims (Weekly): Expecting 209K, Last 206K.
08:30 – Continuing Claims (Weekly): Last 1.774M.
08:30 – Housing Starts (Aug): Expecting 1.32M, Last 1.239M SAAR.
08:30 – Building Permits (Aug): Expecting 1.41M, Last 1.433M SAAR.
08:30 – Philadelphia Fed Manufacturing Index (Sept): Expecting 29.5, Last 47.4.
10:00 – Pending Home Sales (Aug): Expecting 0.9% m/m, Last -2.3% m/m.
10:30 – Natural Gas Inventories (Weekly): Last +40B cf.
The Fed (All Times Eastern)
No public appearances scheduled.
Today’s Earnings Highlights (Consensus EPS Expectations)
No significant quarterly earnings scheduled.
At the time of publication, Guilfoyle had no position in any security mentioned.
