August inflation report is the 'worst' setup for the Fed

The latest economic data reveals a surprisingly robust service sector, contributing to a 0.4% topline growth, with even shelter costs coming in higher than expected. While this may lead to a rate cut, the underlying inflation data suggests it's not a certainty for three cuts by year's end. Service sector inflation is proving stubborn, indicating the Fed faces significant challenges in returning to its 2% target within the next few years.

The current inflationary trajectory appears driven more by strong consumer demand in service sectors rather than tariffs, with slow progress made in bringing these categories back to pre-pandemic levels. This persistent inflation, coupled with rising jobless claims to 263,000, the highest since 2021, creates a complex situation for the Fed. They must balance upside risks to inflation against downside risks to employment, a conflict that complicates monetary policy decisions.

Concerns are also raised about the widening economic disparity, with rising food and shelter costs disproportionately impacting lower-income Americans, while stock markets reach record highs. This "K-shaped" economy presents challenges for policymakers. Furthermore, the independence of the Fed is being questioned, with perceived erosion of this independence potentially impacting inflation expectations and the Fed's credibility.

• The service sector is a key driver of current economic growth, contributing to a 0.4% topline increase.
• Shelter costs are also elevated, contributing to the overall inflation picture.
• Despite expectations, there's uncertainty about whether the Fed will achieve three rate cuts by year's end due to persistent service sector inflation.
• Jobless claims have risen to 263,000, the highest since 2021, indicating potential weakening in the labor market.
• The Fed faces a dilemma balancing rising inflation risks with downside employment risks, potentially impacting their policy decisions.

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Service Sector Inflation and Topline Growth [00:35]

• The service sector is "coming in a bit hot" and is the primary driver of the 0.4% topline growth.
• Shelter costs also came in higher than anticipated.
• The current data does not strongly support the expectation of three rate cuts before the end of the year.
• Service sector inflation is described as "sticky" and "stubborn," suggesting the Fed has significant work to do to reach its 2% target.

"The underlying tenor of the data here doesn't suggest that it's a lock that you're going to get three rate cuts before the end of the year."

This section highlights the inflationary pressures stemming from the service sector and shelter costs, casting doubt on the likelihood of multiple rate cuts.

Drivers of Inflation: Demand vs. Tariffs [01:36]

• The current inflation trajectory seems driven by strong consumer demand rather than tariff pass-through effects.
• Service sectors, which are not typically heavily impacted by tariffs, are contributing to elevated inflation.
• Progress in reducing inflation in service categories back to pre-pandemic levels has been slow throughout the year and the previous year.

"They rather seem to have to do with relatively strong consumer demand."

This part of the discussion focuses on the underlying causes of inflation, pointing towards consumer demand as a more significant factor than tariffs.

Risks of Fed Cutting into Inflationary Environment [02:44]

• There are significant risks in the Fed cutting rates into the current inflationary environment.
• The Fed is moving into an easing cycle, with an expected 25 basis point cut next week.
• However, this easing cycle involves balancing upside risks to inflation against downside risks to employment.
• The current inflation data (CPI) is "still too firm" and not consistent with progress toward the 2% inflation goal.
• The upcoming rate cut is attributed to bad news on employment, not good news on inflation.

"It's the worst kind of setup for the Fed because the two sides of their mandate are in conflict in terms of what should you do with interest rates to address them."

This section elaborates on the risks the Fed faces by cutting rates amidst ongoing inflation, highlighting the conflict within their dual mandate.

Rising Jobless Claims [03:47]

• Weekly jobless claims increased to 263,000 last week, the highest number since 2021.
• This data point aligns with other recent economic figures indicating potential labor market weakening.

"We saw that jobless claims number at 263,000 last week. That's the highest since 2021."

This brief segment points to a worrying trend in the labor market with a significant rise in jobless claims.

Market Expectations vs. Economic Reality [04:08]

• There's agreement that the Fed's mandates are currently in tension.
• A rate cut in September is expected, with at least one more anticipated by year-end.
• The Fed funds futures market projects rates below 3% by the end of next year, which is considered difficult to justify given current inflation levels.
• Inflation is still elevated and moving in the wrong direction.
• The unemployment rate (4.3%) is not far from the Fed's long-term expectation, but 3% inflation is well above the 2% goal.
• The Fed is expected to ease gradually, with projections of only two rate cuts this year.
• Further rate cuts depend on inflation coming down, for which there is currently limited evidence.

"We say at least one more because we're expecting to and then we'll see how the data plays out."

This part of the discussion contrasts market expectations for rate cuts with the persistent inflationary data, suggesting a more cautious approach by the Fed.

Economic Inequality and the K-Shaped Economy [05:57]

• The current economic backdrop is not favorable for lower-income Americans, with increases in food at home prices (0.610%) and shelter costs (0.4%).
• In contrast, stock markets are reaching record highs, indicating a strong "wealth effect."
• This situation is described as the "perils of the American K-shaped economy," making policy judgments difficult due to economic inequality.
• Tariff effects are noted in apparel prices (up 0.5%) and food prices, given the North American supply chain composition.
• Demand for "depressionary services" is increasing, with a 5.9% jump in airfare prices, which is not ideal before a rate-cutting cycle.
• None of the speaker's four formal models are signaling a rate cut currently, despite believing one is coming.
• There is a concern about cutting rates into rising inflation.
• Lower-income Americans are expected to bear the burden of adjustment, contributing to sour public sentiment.

"Those are the perils of the American K-shaped economy, aren't they?"

This segment addresses the growing gap between different economic groups and its implications for policy and public sentiment.

Consumer Sentiment vs. Economic Reality [08:08]

• Consumer sentiment has shown real movements this year, with pessimism in the spring and some improvement since.
• Recently, household surveys indicate a more downbeat view of the jobs market.
• Inflation remains higher than pre-pandemic levels.
• Wage growth has slowed down, and job prospects are not considered good, contributing to negative sentiment.
• Despite the challenges, sentiment does not yet indicate a collapse like that seen going into a recession.

"So I think we're still we're still not in a particularly good place but but looking at a lot of the measures that we look at in sentiment it it also doesn't look like a falling off a cliff like the kinds of what we see going into a recession."

This discussion examines the current state of consumer sentiment, contrasting it with economic realities like inflation and job prospects.

Long-Term Yields and Mortgage Rates [09:48]

• Long-term yields, such as the 10-year Treasury, are not expected to fall much further, even with anticipated rate cuts.
• This is primarily due to persistent inflation, which may embed a risk premium in yields.
• Fiscal concerns are also a worry, with the potential for a relationship to form between budget deficits and Treasury yields over time.
• Global bond yields have drifted up, making them more attractive to investors.
• 10-year Treasury yields are expected to remain rangebound or even drift higher absent a recession.
• A significant economic slowdown or recession could cause the 10-year yield to fall to 3.5% or lower.
• Mortgage rates are not expected to come down much further as they are influenced by long-term yields, inflation expectations, and growth outlook, rather than direct Fed control.

"We don't think that 10-year Treasury yields will necessarily fall sharply from here absent a recession if we do see a significant slowdown in economic growth or or even a recession we'd probably see the 10-year fall maybe to that 3 and a half% or lower level."

This section delves into the outlook for long-term yields and mortgage rates, linking them to inflation, fiscal concerns, and the potential for economic slowdown.

Erosion of Fed Independence and Credibility [12:19]

• There are ongoing concerns about the Fed's independence, with recent developments potentially impacting this.
• The Fed's independence is seen as having been eroded.
• This erosion is contributing to a yield curve steepening, with investors taking attacks on the Fed seriously.
• There is a perception that the Fed is moving away from its official 2% inflation target, with market players suggesting an "effective target" of around 3%.
• While the official target may not change soon, the market's perception of the target is significant.
• The outcome of a specific legal case (Lisa Cook's case) is seen as crucial for ensuring the Federal Open Market Committee has a buffer from short-term political influences.
• Losing control of monetary policy is a potential, though not imminent, concern.
• The Fed's credibility is paramount for managing inflation expectations, and its erosion could lead to persistent inflation.

"I think that the Fed's independence is has been eroded and I think that we just need to call it as it is."

This discussion focuses on the perceived erosion of the Fed's independence and the potential consequences for its credibility and the management of inflation.