The most important
economic report in the week ahead is the US December Consumer Price Index on
January 12. To be sure, the Federal Reserve targets an alternative
measure, the deflator of personal consumption expenditures. However, in
this cycle, when households, businesses, investors, and policymakers are
particularly sensitive to inflation, CPI, which is reported a couple of weeks
before the PCE deflator, has stolen the thunder. In explaining the
surprise acceleration to 75 bp rate hikes in the middle of last year, Fed Chair
Powell cited the CPI (and the preliminary results of an inflation
expectations survey conducted by the University of Michigan).
The issue is no longer being framed about the peak of
US inflation but the pace at which it will converge to the target. Fed
officials and the December FOMC minutes have pushed hard against the easing of
financial conditions and the expectation of a rate cut later this year. The
reaction function of the Federal Reserve to the continued strength of the labor
market, which is not just about wage-push inflation but also the demand for
core services, and what appears to be above trend growth, warns that the risk
of another 50 bp rate hike is greater than what current pricing suggests. The
market seemed to focus more on the softer than expected average hourly earnings
in the December jobs data more than the downtick in the unemployment rate to
3.5%, the cyclical low post-Covid and the 717k jobs reported by the household
survey. Financial conditions are the easiest since mid-September.
The December CPI will help shape market expectations
for the FOMC meeting that concludes on February 1. The pricing in the Fed funds futures implies the
market favors a quarter-point move and sees about a 25% chance of a half-point
move. Subjectively, we suspect the risk is somewhat greater, and not because we
have any special insight into the CPI figures. Rather it comes from game theory
insight into incentives. A 50 bp hike would underscore the FOMC's
resolve, and perhaps boost its anti-inflation credentials that some believe
have been tarnished. Those credentials could be useful when the Fed signals it
is pausing even though inflation will most likely still be well above target. A
half-point move would signal determination to bring the terminal rate above 5%.
The terms of the inflation debate have shifted. It is not whether it is has peaked. Barring a new
shock, this seems consensus. The key policy issue now is how fast will it slow.
The median forecast in Bloomberg's survey is that the CPI was unchanged in
December. That would put the Q4 annualized pace at about 2%, the same as in Q3.
Recall in Q1 and Q2 last year, the annualized pace was more than 10%. The
year-over-year rate would slow to 6.7% from 7.1%.
The core rate is projected to rise by 0.3%. It would mean at an annualized pace in Q4, core
CPI rose around 3.2%. That is down from around 4.5% in Q3 and 8.4% in Q2. The
year-over-year rate would slow to 5.7% from 6.0%.
While price trends appear to be moving in the right
direction, the Fed cannot be confident that the momentum can be maintained. The economy is showing great resilience. The Fed
correctly saw through the contraction in H1, and although it has continued to
tighten policy, the economy appears to have finished the year on a robust note.
Growth possibly exceeded 3% (at an annualized rate) for the second consecutive
quarter. The median projection by Fed officials last month was that long-term
non-inflation growth is around 1.8%. Fed officials seemed adamant in the December
minutes that premature easing of financial conditions would be resisted.
Financial conditions have become easier and ahead of the weekend, with the
dramatic equity rally, the sharp decline in US rates, and the dollar's
sell-off, financial conditions eased to levels last seen in mid-September.
A 50 bp move would at the same time, give it room to
maneuver at the upcoming meetings. It
can choose between front-loading this year's work or net additive
The international economic environment is uncertain
and greater flexibility may be helpful. The length and extent of the economic disruption from China's
abandonment to its zero-Covid policy early last month is not clear. The ECB and
the Bank of England warn that their respective economies are likely contracting
and will do so into next year. The ECB seems somewhat more hopeful that the
recession can be short and shallow. February WTI tested the lows for the year
in mid-December around $70 a barrel, around where the US said it would consider
replenishing the Strategic Petroleum Reserves. The upper-end of the range
that has dominated in the past six-months extends a little above $90.
On real broad-trade weighted terms, the dollar fell by
about 1.9% in December, its largest monthly decline since June 2020. In the fourth quarter, the greenback fell by more than
5% against the other G10 currencies but the Canadian dollar. The dollar's
heavier tone is consistent with the modest easing of US financial conditions
over the past two months. A 50 bp hike would not be accelerating the dollar's
appreciation, as was the case earlier this year, when it aggravated inflation
pressures, like higher food and energy prices for other countries. In turn this
encouraged tighter monetary policy and slower growth.
One thing that seem fair to say about inflation expectations is that they are not particularly accurate. This seems as true of the market-based measures as surveys. As we noted, Powell referred to the University of Michigan's survey. Last January, the one-year inflation was put at 4.8%. It stood at 4.4% in the final December reading. January 2023 preliminary results are due on January 13, the day after the CPI release.
Officials seem to put more stock in the longer-term
expectations (5-10-years). Before
Covid struck, it stood at 2.2% (December 2019). Before Russia's invasion of
Ukraine, it was at 3.1% (January 2022). It finished last year at 2.9%. The 5-
and 10-year breakeven rates (the difference between the inflation-protected and
the conventional notes) were little changed in December. The five-year
breakeven was off less than two basis points to 2.38%, while the 10-year
breakeven slipped almost four basis points to slightly below 2.30%.
For the record, Bloomberg' survey found a median
forecast for CPI to end this year at 4% before falling to 2.5% in 2024. The median forecasts for PCE deflator are around
3.5% and 2.3%, respectively. The Fed's Summary of Economic Projections has a
median for the PCE deflator of 3.1% this year and 2.5% next year.
The New York Federal Reserve does its own survey of
consumer inflation expectations. The
December results will be published on January 9. In December, the one-year
inflation expectation fell by 0.7% to 5.2%. The three-year expectation eased by
0.1% to 3.0%. The five-year inflation expectation slipped 0.1% to 2.3%.
II
China is expected to report December
data. It is
unlikely to have much impact. The disruption from its Covid policy reversal is
generally recognized. Some traffic data cited suggests that there has been
increased activity in some large cities, like Beijing, that some suggest is
past the peak. Still, the experience from other countries would warn of another
wave. In any event, sometime in the spring, many observers anticipate the
world's second-large economy will get a bounce from the re-opening but also
from the additional stimulus that the government is expected to provide.
The earlier indications suggest that
the common Covid variant in China (so far) is the Omicron. That would appear to rule out a new
variant that makes it milder since the end of November. If the zero-Covid
policy was not reversed because of that, what prompted the decision? We suspect
that it was failing. It may have been slowing the spread of the virus, but it
was deterring economic activity. Many accounts focus on the breakdown of
property market and reports suggest that Beijing is about to take fresh
initiatives to reanimate the sector by allowing large developers to boost
leverage, borrow more money, and take longer to reach the new targets. However,
slowing Chinese growth challenges the very essence of the Communist Party pact
with the people.
Allow the dictatorship of the people
(Chinese Communist Party membership estimated around 96 mln) and it will
deliver the goods in a literal sense of increased living standards. China's per capita GDP rose nearly
12-fold in the 20 years through 2021. In the previous 20-years, per capital GDP
rose by about 5.3-times. The slowdown is even more noticeable in the past
10-years under Xi. In the decade through 2021, per capita GDP rose
2.2-times, the weakest decade since the start of Deng Xiaoping's reforms.
The yuan fell by nearly 7.9% against
the US dollar last year. It was the first annual loss in three years. Some argue that with
growing trade surplus, the yuan should have risen. The December trade figures
are due on January 13. However, through November, it recorded a surplus of
nearly $800 bln. That compares with a $577 bln surplus in the first 11
months of 2021. Still, it seems well more complicated than that, and the lack
of transparency befuddles attempts to square the proverbial circle. Are all the
activities of state-owned banks really activities of the state? What is the
role of China's shadow banking? How does conducting more trade in yuan impact
the pressures on the exchange rate? How are hedges of foreign portfolio
investments in China reflected in balance-of-payments analysis?
In any event, it seems beyond doubt that
the yuan is a closely managed, even if all the particulars are not known. For businesses and investors,
the important question may not be so much how Beijing manages
the exchange rate, as if it must be consistent over time, but where it is
headed. As a useful rule of thumb, we think that directionally, Beijing wants
the yuan to track broad dollar moves. While central bank officials say that it
seeks a broadly stable exchange rate, it refers to a trade-weighted basket
(CFETS, China Foreign Exchange Trading System). To simplify matters, we think
it is useful to expect the yuan to move in the same direction as the yen and
euro against the dollar, with a little more weight given to the euro. That
said, investors want to look past Covid and is hopeful that after several
rounds of government initiatives, the property market may stabilize, and the
yuan posted independent gains to start the new year.
Disclaimer
Reviewed by Marc Chandler
on
January 07, 2023
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