Low Inflation Allows The Fed To Cut Rates In September

Core Inflation Falls

The only major economic report that was released on Friday was the July PPI-FD (producer price index final demand) reading. It showed there was a big decline in core inflation which missed estimates significantly. Firstly, headline PPI was 0.2% on a monthly basis which met estimates and was above the 0.1% price growth in June. On a yearly basis, it was 1.7% which met estimates and June’s reading. The data gets more interesting when looking at core results. Monthly PPI without food and energy was -0.1% which missed estimates for 0.2% and June’s reading of 0.3%.

As you can see from the chart below, yearly core PPI fell from 2.3% to 2.1% which missed estimates for 2.4%. A slight increase was expected; instead we got a solid decrease. As the chart shows, in the past few months core PPI has faded, while core CPI has been consistent. It will be great news for the Fed’s rate cut aspirations if core CPI falls below 2%. It will provide further evidence that the recent rate cut in July and the coming cut in September are the correct decisions. The July CPI report comes out next Tuesday.

Finally, core inflation excluding trade services was even weaker as it was -0.1% on a monthly basis which missed estimates for 0.2% and June’s 0%. Negative growth on an easy comp shows underlying weakness. On a yearly basis, this reading fell from 2.1% to 1.7% which was the largest drop. Energy prices drove monthly headline inflation and hurt yearly inflation as prices were up 2.3% monthly and down 4.4% yearly. Food inflation was 2.5%. As you can tell, trade services drove inflation as yearly price growth was 3.3%. Monthly core PCE was -0.1% and headline PCE was 0.1%.

The July Personal Income and Outlays report comes out on August 30th. Once again, core PCE inflation will be below 2% which allows the Fed to cut rates. My concern with core inflation starts in Q1 2020. At that point, the Fed will need to stop cutting rates because inflation is high, or it will be able to cut rates because the economy is weaker. The third option is the economy rebounds modestly allowing the Fed to stop cutting rates without catalyzing a recession. If the Fed cuts rates 2 more times this year like the futures market expects, there won’t be much room to cut them further in 2020 anyway.

Negative Morgan Stanley Charts On Capex & Hiring

Morgan Stanley’s measurements of hiring activity and capex plans have fallen. As you can see in the chart on the right, the 3 month moving average of hiring plans are the lowest since 2017. This is like the results in the JOLTS report. The JOLTS report showed hiring fell 2.2% yearly which was the lowest growth rate since February 2017. These hiring reports signal the economy isn’t in a recession, but growth is headed in the wrong direction. I need to see a spike in jobless claims before calling for a recession. The strong Q2 consumption growth rate certainly doesn’t jive with a big decline in hiring. Also keep in mind, the jobless claims data is from August and the JOLTS report is from June. If hiring falls further in the July and August JOLTS reports, it will be even more out of line with initial claims.

As you can see from the chart on the left, capex plans are the weakest since the financial crisis. That makes sense because the trade war has created uncertainty. There haven’t been huge direct impacts from the trade war. That would likely come if autos are ever taxed. However, firms are saying they are pulling back despite not seeing weakness, because they are afraid of the next move in the trade war. This was a bad time to start a trade war because the global economy is in its third slowdown since the financial crisis. At least the service sector is doing better than manufacturing in the global economy.

More Negative Readings From Morgan Stanley

The table below shows the subcategories that make up Morgan Stanley’s Business Conditions index. As you can see from the bottom chart below, the composite and 3 month moving average of the headline index both show the economy is in the worst shape since the financial crisis. I take issue with this index showing data nearly as weak as the financial crisis because this isn’t even a recession yet. When the economy falls into a recession, it likely won’t get nearly as bad as the last one because there is no bubble in the biggest asset consumers own (housing) and the banking system isn’t unstable.

Let’s look at some of the details in the table above. As you can see, the manufacturing sub-index fell from 33 to 21. The shocking part of this is the services sub-index fell from 50 to 14. If that’s anyway in tune with the ISM PMI, it will fall below 50. I’m anticipating more service sector weakness in America in August and September because 40% of the latest round of tariffs are capital goods and 40% are consumer goods. The overall business conditions expectations index fell from 43 to 21 from June to August. Finally, the credit conditions index shows little weakness as it fell from 60 to 57. The Fed’s rate cut may have helped that index.

Conclusion

Inflation is falling. I expect the PPI report to be a leading indicator for CPI and PCE inflation. I already expected core PCE inflation to be below 2% for the rest of the year. This Fed assumption allowed it to cut rates in July. Morgan Stanley’s data suggests the economy has recently gotten much worse. I wouldn’t be surprised to see data in August weaken since the tariff announcement likely hurt sentiment. However, keep in mind that the hard data from July hasn’t even come out. Some investors might discount solid hard data reports if they see weakness coming in August. The only way we will find out is for these reports to come out in the next few days. 

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