- Fed’s reluctance to cut rates further will be reinforced if core PCE deflator shows a sustained advance
- U.S. consumer sentiment will be watched for any further weakness
- U.S. durable goods orders expected to confirm weak outlook for U.S. manufacturing sector
- U.S. government shutdown is averted
fFed’s reluctance to cut rates further will be reinforced if core PCE deflator shows a sustained advance — The consensus is for today’s Aug PCE deflator report to be unchanged from July at +1.4% y/y. However, the Aug core PCE deflator is expected to edge higher to +1.8% y/y from July’s +1.6%. The PCE deflator is the Fed’s preferred inflation measure.
Today’s expected core PCE deflator report of +1.8% y/y would represent a 0.3 point increase from the 2-year low of +1.5% posted this past spring and would be only 0.2 points below the Fed’s +2.0% inflation target. The PCE deflator has recently been on the rise with the measure up +2.4% in June and +2.2% in July on a 3-month annualized basis, i.e., above the Fed’s +2.0% inflation target. The core CPI is also on the rise as seen by its increase in August to a 10-year high of +2.4% y/y and to a lofty +3.4% on a 3-month annualized basis.
The Fed will not be alarmed by the recent increase in the inflation statistics because the Fed has clearly stated that its 2.0% inflation target is symmetrical. That means that the Fed will allow inflation to temporarily rise above +2.0% to preserve a long-term inflation average near +2.0%.
Yet if inflation is running near or above target, the Fed has little justification for a further cut in interest rates, particularly if GDP remains near or above the Fed’s estimate of the long-term U.S. potential GDP rate of +1.9%. If today’s core PCE deflator in fact rises to +1.8%, then the Fed is likely to take that as an indicator that monetary policy is easy enough and that further easing is not necessary at present, assuming that overseas and trade risks do not worsen.
The Fed at its meeting last week cut the funds rate for the second time, but expressed a reluctance to cut rates further. The median Fed-dot forecast at last week’s meeting was for no more rate cuts through 2020 and then a +25 bp rate hike in 2021 and another rate hike in 2022. A strong deflator report today would likely solidify the Fed’s consensus view that further rate cuts are not necessary.
A less dovish Fed would of course be disappointing for market participants. The market is expecting a further -64 bp of Fed rate cuts (i.e., 2.6 rate cuts) through the end of 2020, according to the Dec 2020 federal funds futures contract. The Fed last week cut its funds rate target by -25 bp to 1.75-2.00%, meaning the market is expecting a further cut to at least 1.25-1.50% by the end of 2020.
U.S. consumer sentiment will be watched for any further weakness — The market consensus is for today’s final-Sep University of Michigan U.S. consumer sentiment index to show a small upward revision by +0.1 point to 92.1, which would produce a +2.3 point increase from August rather than the preliminary increase of +2.2 points. However, the index would still be in weakened shape at only 2.3 points above August’s 3-year low of 89.8. The markets were a bit alarmed by the news earlier this week that the Conference Board’s U.S. consumer confidence index in September fell sharply by -9.1 points to 125.1.
Consumers are losing some confidence in the economy due to the recent media talk about the chances for a U.S. recession tied to trade tensions and slower overseas growth. The U.S. economy simply cannot afford to lose its support from consumers. In Q2, the only reason that GDP was as strong as it was at +2.0% was because of the +4.6% surge in consumer spending, which contributed a hefty 3.0 percentage points to the report. The only other category that contributed to GDP growth in Q2 was government spending with a +0.82 point contribution. The other categories subtracted from growth including a -0.25 point subtraction by business investment, a -0.68 point subtraction by net exports, and a -0.91 point subtraction by inventories.
Looking ahead, the consensus is for U.S. GDP to fade slightly to +1.9% in Q3 and +1.7% in Q4-Q1, before stabilizing near 1.8% during the remainder of 2020. On a calendar year basis, the consensus is for U.S. GDP in 2019 to ease to +2.3% from 2018’s strong rate of +2.9%, and then ease further to +1.7% in 2020. The U.S. economy is slowing due to (1) the fading effects of the 2018 tax cut, (2) slower growth in China and Europe, and (3) weak U.S. business investment tied to trade uncertainty.
U.S. durable goods orders expected to confirm weak outlook for U.S. manufacturing sector — The market consensus is for an Aug durable goods orders report today of -1.2% and +0.2% ex-transportation, following July’s report of +2.0% and -0.4% ex-transportation. Meanwhile, the key measure of capital spending, Aug capital goods new orders ex defense and aircraft, is expected to be unchanged m/m after July’s small increase of +0.2%.
The U.S. manufacturing sector has now sunk into a recession. U.S. manufacturing growth has been negative on a year-on-year basis in the past two reporting months at -0.5% y/y in July and -0.4% y/y. In addition, the U.S. ISM manufacturing index in August fell by -1.2 points to a 3-1/2 year low of 49.1, falling into contraction territory below 50.0 for the first time since early 2016.
The ISM manufacturing new orders sub-index was even weaker in August, falling -3.6 points to a 10-year low of 47.2. The fact that the new orders sub-index is now below 50.0 suggests that manufacturing executives are seeing a decline in new orders as a result of the slump in business investment and weak overseas growth in China and Europe.
U.S. government shutdown is averted — The Senate on Thursday approved the same continuing resolution approved by the House last week, which funds the government through Nov 21. If President Trump signs the CR, there will be no shutdown next week on Oct 1