Forecasting Fed Policy: Hints From Hard Data

As expected, the Federal Reserve left interest rates unchanged. The Fed Chair acknowledged a high degree of uncertainty about the effects of tariffs: “Ultimately the cost of the tariff has to be paid, and some of it will fall on the end consumer. We know that’s coming, and we just want to see a little bit of that before we make judgments prematurely.”

The “dot plot” took a surprising hawkish turn. Seven FOMC members expect no rate cuts in 2025, compared to four in March, and two expect a single quarter-point cut, compared to four in June. But the hawkish pivot occurred against a backdrop of uncertainty as Powell admitted that the projected policy path is only a guess. The Fed’s forecast of inflation and growth has become clouded in the face of the unknown effects of tariffs: “We haven’t been through a situation like this, and I think we have to be humble about our ability to forecast it.”
 

 

It is not surprising that Fed policy makers have adopted a wait-and-see attitude as they watch for clues from the hard economic data.
 

 

Hints from Hard Data

Now that we have had a decent interval since the “Liberation Day” announcement, investors are starting to see hints of how the economy is evolving from the hard data. Generally speaking, the economy is experiencing some softness. The Economic Surprise Index, which measures whether economic data is beating or missing expectations, is falling.
 

 

Let’s start with the weakest and most cyclical part of the economy: housing. The housing sector has been extremely weak, according to New Deal democrat:

Permits (gold) declined -29,000 annualized to 1.393 million, the lowest number since June 2020. Single family permits (red) also declined, by 25,000 annualized, to 898,000, the lowest in 2 years. Starts (light blue) declined -136,000 annualized to 1.256 million, the lowest since May 2020.

 

Employment is also showing signs of stalling. Initial jobless claims (blue line) rose sharply recently, though levels are still holding within a historical range. Continuing claims (red line) has increased to a new cycle high, indicating that job seekers are finding it increasingly difficult to get jobs.

 

Real-time indicators of employment are also weakening, as evidenced by a decline in individual income tax withholding.
 

 

On the other hand, the American consumer is showing no signs of weakness. Numerous credit card surveys attest to the resiliency of consumer spending. The Redbook Index of same-store sales of U.S. general merchandise continues to grow steadily.
 

 

To be sure, some of the consumer spending could be attributed to households front-running tariff increases. The negative surprise in the May retail sales report is an indication that any front running is over.

New Deal democrat’s analysis of the retail sales report had two main takeaways. He reiterates his belief that “consumption leads employment”, and “the consumer front-running of tariffs has ended, and payback (of unknown duration and strength) has begun.”
 

 

Investors are about to find out how the economy is progressing now that the tariff-related noise has passed. The hard data in the coming months will tell the story.
 

 

The Stagflation Question

In summary, investors are starting to see preliminary signs of economic weakness. However, there is no need to panic because, as the FOMC statement correctly states, “economic activity has continued to expand at a solid pace”. In the absence of the tariff-related price increases, the economy could be described as undergoing a soft landing and it would be entirely appropriate for the Fed to cut rates.

The risk is inflation. Inflation is declining and nearing the Fed’s 2% target, but Fed policy makers have to be mindful of the price stability part of the organization’s mandate. What happens to inflation and inflation expectations in the coming months?

Analysis by former Fed economist Claudia Sahm highlighted some  possible good news on tariff pass-through price increases. She pointed out that the apparel CPI, which is a category that’s highly sensitive to tariffs, saw a decline of -0.4% in April.
 

 

She attributes the decline to a combination of factors. One is price reductions by the foreign manufacturer as the “longer production cycles may have given US apparel importers more leverage than importers in other industries”. Another is the phased implementation of tariff collection, which hasn’t fully affected prices yet. Importers could also choose to absorb some of the price increase, which is reflected in the most recent compression between CPI and PPI.
 

 

With the caveat that the apparel price data is highly preliminary, Sahm concluded:

The declines in apparel consumer prices in recent months also suggest greater demand sensitivity and some tariff cost sharing by foreign producers. That would imply a smaller boost to inflation from tariffs, as opposed to simply a delay in the boost.

That’s the good news. The bad news is the U.S. may be on the verge of becoming drawn into a Middle East war. Wars are like roach motels. It’s easy to get into, getting out and winning a stable peace is another matter.

The main risk for financial markets is that the effects of the war become highly prolonged and begin to affect inflation by boosting commodity prices. Consider how the Fed and the global economy reacted when Russia invaded Ukraine in February 2022. While history doesn’t repeat itself but rhymes, the market reaction gives investors clues to the risks of a major war with Iran.
 

 

As the accompanying chart shows, oil prices rose sharply as Europe experienced a sudden catastrophic shortage of natural gas. The prolonged nature of the conflict boosted the relative performance of energy stocks (top panel, dotted red line). Food prices, as proxied by agricultural commodities, also rose. As a reminder, the increase in food inflation was a key issue in the last U.S. election. The Fed had started to raise rates and move off ZIRP when the invasion began. The 2-year Treasury yield, which is a proxy for the terminal Fed Funds rate, increased steadily.

Today, the markets reacted when oil prices rose, but agricultural commodity prices remain tame. One key difference between 2022 and today is the weakness in global cyclical indicators such as the copper/gold and base metal/gold ratios. Global central banks are easing today compared to the tightening bias of 2022.

If the war were to be prolonged, or if Iran undergoes a chaotic regime change, what happens to commodity prices? Rising oil and food prices will eventually feed into inflation and inflation expectations. The Fed and other central banks would be faced with the problem of stagflation: weak growth and rising inflation.

In conclusion, the Fed is on hold and waiting the data to guide its monetary policy. Preliminary data shows that the economy is slowing, but not in an alarming recessionary fashion. Early indications from apparel CPI point to modest tariff pass-through effects on inflation, which is positive news. The key risk is that a prolonged Middle East conflict could boost commodity prices and raise the odds of a stagflation scenario of weak growth and rising inflation. From that perspective, investors should assign a high level of uncertainty to the market expectations of two quarter-point rate cuts in 2025.