U.S. economic data fight? Who should the Fed trust?

　　For more than a month, the market has been in full swing on the Fed’s slowdown in interest rate hikes, global risk appetite has increased, US stocks have rebounded sharply from the bottom, US bond yields and the US dollar have both fallen sharply.
　　The S&P 500 index rebounded from the bottom of 3490 points in mid-October to above 4000 points, and the rebound rate of this round has reached 15%. From the previous high of 114.8 to around 104, the offshore RMB exchange rate has appreciated significantly, and the USD/CNH exchange rate has appreciated from 7.37 to within 7.
　　This wave of global market recovery is a correction to the previous excessive Fed rate hike expectations, but the road to recovery may not be so linear. The recent “fighting” of some key economic data in the United States may increase short-term market volatility.
　　On the one hand, from the perspective of US inflation, the actual inflation level is still as high as 7.7%, and some leading indicators of inflation have begun to decline, such as the decline in commodity prices and the decline in new rent prices; Wage growth remains high.
　　On the other hand, from the perspective of the U.S. economy, some leading indicators indicate that the U.S. economy may enter a recession in the future, such as the PMI index has fallen below the dry-boom line, the real estate market has cooled significantly, and exports to the U.S. from many countries have begun to decline; but in the third quarter The U.S. GDP growth rate is still 2.9%, but the employment data that the Federal Reserve values ​​more is still strong, and the unemployment rate remains at a low level of 3.7%.
　　Faced with these contradictory data, which one should the Fed believe? The recent statements of many Fed officials have also revealed differences on future policies.
　　Federal Reserve Chairman Powell’s speech on November 30 released some “dovish” voices. He said, “When we are close to a constraint level sufficient to bring inflation down, it makes sense to slow down the pace of rate hikes. Slow rate hikes The timing may come at the December interest rate meeting at the earliest.” New York Fed President Williams is somewhat “hawkish”, he believes that the outer and middle pressures that affect inflation are declining, but the inner price pressure is falling It will take time. The implication is that the Fed is still a long way from cutting interest rates.
　　The upcoming December Federal Reserve meeting may adopt a compromise approach: on the one hand, slow down the pace of interest rate hikes to 50bp; on the other hand, raise the end point of interest rate hikes in 2023 to above 5%. This kind of compromise of “short pigeons and long wins” may be an optimal strategy that takes into account the current contradictory information.
“Onion” is a duplicity

　　In October, the U.S. CPI increased by 7.7% year-on-year. Although it has fallen by 1.4 percentage points from the high point in June, the absolute level is still far above the Fed’s target. On the surface, inflation in the United States is still so high, why did the market start to trade inflation down in advance?
　　One reason is that the CPI inflation indicator is a relatively lagging data, and some leading indicators seem to indicate that US inflation will decline in the future. Another reason is that it will take some time for the Fed’s tightening policy to fully transmit to the real economy and affect inflation. In other words, inflation data does not fully reflect the impact of the Fed’s cumulative interest rate hike of 375 basis points since 2022. These effects will gradually be reflected in the future, which will lead to a downward trend in inflation.
　　We can use Williams’ model of comparing inflation to an onion to dissect some contradictory information inside the “onion” of US inflation.
　　According to Williams, the outer layer of the “onion” is the price of raw materials and traded goods, such as the price of basic commodities such as crude oil, iron, and timber; the middle layer of the “onion” is the price of finished goods, especially the price of durable goods such as automobiles, home appliances, and furniture. ; The inner layer of the “onion” is the most important underlying inflation, reflecting the overall imbalance in the economy and the job market, with reference to service industry, housing and labor cost prices.
　　Let’s first look at the external causes of inflation. The United States is the world’s largest crude oil consumer, and the rise and fall of crude oil prices will be directly reflected in the CPI. The price of US oil has dropped from US$130 per barrel at the beginning of the year to around US$80 per barrel at present. In the US CPI, the year-on-year growth rate of energy prices has dropped from 41.6% in June to 17.6% in October.
Figure 1: Trends in US Core PCE Inflation

Data source: BEA, BLS
Figure 2: The U.S. labor supply-demand gap remains large

Data source: BLS, etc.

　　So what about the performance of durable goods prices? Affected by the Federal Reserve’s continuous interest rate hikes, the demand for durable goods has begun to drop significantly. In the third quarter, US consumer spending on durable goods fell by 0.3% (annualized quarter-on-quarter), showing negative growth for two quarters. In the CPI, the price of durable goods in October increased by 4.8% year-on-year, which has fallen sharply by about 14 percentage points from the high point at the beginning of the year.
　　The evidence shows that the inflationary pressure indicated by the outer and middle layers of the “onion” has declined significantly, but why does the overall level of inflation in the United States remain high? The core reason is that the price contained in the inner layer of the “onion” remains high.
　　An important part of the inner layer of the “onion” is the rental price. In the CPI, the rental price in October increased by 7.1% year-on-year, and is still on the rise. Obviously, the housing prices in the United States have fallen, and some rent indices have also turned down. Why is the growth rate of rent prices in the CPI still rising? Because housing rental contracts are often long-term, once a rent is negotiated, it will remain unchanged for a period of time, and these old rents will not immediately change with changes in the housing market.
　　As Powell analyzed, housing inflation tends to lag other prices at inflation inflection points because leases are reset at a slower pace. “As long as inflation on new leases continues to decline, we expect housing services inflation to begin to decline at some point in 2023. In fact, this decline in inflation is the basis for most inflation-down forecasts.” The Fed is well aware of recent market volatility Trading logic and forecast basis, so why didn’t the Fed fully accept the market’s expectations? Because another core of the “onion” inner layer may also be the most important element of the Fed, labor prices have not dropped significantly.
　　Prices covering a wide range of services such as health care and education account for more than half of core PCE and are the most important component of U.S. inflation. Since wages constitute the largest cost of these services, understanding the U.S. labor market can unlock the key to U.S. inflation.
　　All U.S. private-sector hourly wages rose 5.1% year-on-year in November, rebounding from the previous month and failing to extend the downward trend of previous months. Moreover, the growth rate of wages is still significantly higher than the level of about 3% before the epidemic, which is the most worrying issue for the Fed. In Powell’s view, “Nominal wages have grown much faster than would be consistent with 2 percent inflation. We are a long way from restoring price stability.”

　　Due to the epidemic and some other reasons, the labor supply in the United States has declined, which makes the demand in the labor market greater than the supply gap when the demand remains unchanged. The purpose of the Federal Reserve’s tightening policy is to suppress labor demand and bring the labor market back into balance, thereby forming a sustainable wage growth.
Can’t have both fish and bear’s paw

　　The Fed wants to have it both ways. The ideal is very fulfilling, but the reality is often much crueler. Controlling inflation will inevitably suppress demand, and the economic downturn has gradually become a reality.
　　Some leading indicators of the U.S. economy indicate that a recession in the U.S. economy is inevitable in the future. In November, the U.S. ISM PMI index fell to 49%, which was the first time in the post-epidemic era that it fell below the line of prosperity and prosperity, and issued an early warning to the health of the U.S. economy. Historically, PMI falling below 50 does not necessarily trigger a recession. For example, in the second half of 2019, the U.S. PMI briefly fell below the line of dryness and prosperity, but no recession occurred. However, once the PMI falls below 45%, almost all recessions have occurred.
　　The housing market is highly sensitive to interest rates, and the rapid rate hikes by the Federal Reserve have significantly cooled the US housing market. U.S. 30-year home mortgage rates have soared above 7%, higher than before the 2008 financial crisis and up about 4 percentage points from the start of the year.
　　The housing market index of the National Association of Home Builders has fallen to the low level during the epidemic, and housing sales have become deserted. The number of existing home sales in the United States in October was 4.43 million units, which is already lower than the average level in 2019 before the epidemic and higher than the beginning of the year 30% down. Residential investment has fallen sharply for two quarters. In the third quarter, the quarter-on-quarter annualized rate of residential investment was -26.4%. This alone negatively stimulated GDP growth by 1.4%.
　　Since the cycle of the real estate market is very long, the U.S. housing market’s U-turn this time may be the end of a long-term real estate bull market that began in 2012, and its impact on the U.S. economy will last for a long time.
　　Exports from other countries also fell sharply, signaling that the slowdown in the U.S. economy has started to spill over into global trade. In November, South Korea’s exports fell by 14% year-on-year, negative growth for two consecutive months; in October, China’s exports to the US fell by 12.6% year-on-year, negative growth for three consecutive months.
　　From the perspective of the labor market, based on the experience of the past 40 years, the Federal Reserve needs to maintain a slight labor demand gap (that is, the labor demand is slightly smaller than the labor supply) in order to stabilize inflation at a level of around 2%. But what is different from previous economic cycles is that due to the permanent reduction in labor supply compared to before the epidemic, if the Fed wants to achieve a slight gap in labor demand, it must suppress more labor demand than before. This may require the Fed to pay a greater economic price than in previous cycles to win the battle against inflation.
　　The Federal Reserve’s current economic forecast is still relatively optimistic, believing that the U.S. economy can still achieve a “soft landing”. The economic forecast given by the Federal Reserve in September shows that Fed officials generally expect the US economy to maintain a growth rate of 1.8% in 2023.
　　At present, the market is also trading according to the ideal combination of economy and inflation. The market expects that even if the U.S. economy undergoes a recession, it will be shallow. This is also a core logic behind the recent sharp rebound in US stocks. If the Fed fails to brake the car and the economy slides into a moderate recession, then the expectations of US stocks will need to be revised. If the Federal Reserve maintains the benchmark interest rate at a high level of 4%-5% for a long period of time, it is still a mystery whether the economy can resist it. After all, the US economy has not experienced such a high interest rate in the past 20 years.
Figure 3: U.S. 10-year Treasury yields have fallen sharply

Data source: Choice
ambiguous expectations

　　In the face of “fighting” economic data, the policy expectations released by the Federal Reserve are also relatively ambiguous. On the one hand, fear that inflation will continue to recur. After all, in the past two years, the Fed’s predictions on inflation have repeatedly “slapped the face”, making the Fed increasingly rely on current indicators to make decisions instead of forecasts; on the other hand, the Fed Fear of a too-rapid economic downturn and worries about financial stability.
　　At the Federal Reserve meeting in December, there is a high probability that the pace of interest rate hikes will be adjusted to 50bp, which is the “candy” that the Federal Reserve gives to the market. Powell had previously announced that “the time to slow down interest rate hikes may come at the earliest interest rate meeting in December.” Slowing
　　down the pace of interest rate hikes does not mean that the policy will turn around soon, and the Fed is likely to further increase interest rates The expectation of the end point, and maintain the benchmark interest rate at a “restrictive level” for a long time, until the actual inflation can be greatly reduced.
　　St. Louis Fed President James Bullard said financial markets were underestimating the chances that Fed policymakers would raise interest rates more aggressively in 2023 to curb inflation. He believes the Fed needs to get its policy rate at least at the low end of the 5%-7% range to meet its goal of making rates sufficiently restrictive.
　　Powell also said, “Terminal interest rates are likely to need to be higher than the figures at the September meeting and the summary of economic forecasts.” Powell further emphasized that further raising interest rates to control inflation and the need to keep policy rates at restrictive levels for a sustained period The importance of issues such as the period of time is far greater than the timing of the slowdown in interest rate hikes.
　　The Wall Street Journal reporter Nick Timiraos, who is regarded as the “Fed mouthpiece”, recently wrote that in the quarterly forecast given by the Federal Reserve meeting in December, the peak interest rate predicted by Fed officials will rise to 4.75%-5.25%.
　　Previously, in September, Fed officials predicted a peak rate of 4.5%-5%. This means that the Fed is likely to increase the water level of the end point of interest rate hikes.
　　CICC believes that the current market expectations may be a bit “preemptive”. The current speed of raising interest rates is no longer that important, and continuing to raise interest rates too quickly will easily induce financial risks. However, when inflation is still as high as 7%, it may be too early for the market to expect that the end point of interest rate hikes will go down. Policy changes may still have to be done step by step and cannot be achieved overnight.
　　CICC also believes that the current pricing of 10-year U.S. bond yields may have deviated. U.S. stocks only fell by 15% during the 200bp rise in U.S. bond interest rates, which did not reach the average decline of 20% in a mild recession. The current too low equity risk premium shows that the preparation for future profit decline is insufficient.