We believe Fed have now gone on the other side of being too careful about inflation. And that risks an event where there will be a sharp meltdown in growth because of Fed’s reaction function being too late. Three months of softer core inflation readings, rising continuing jobless claims, and weak US consumer makes us believe that Fed is almost about to do a policy error of waiting for too long. We believe markets are under-pricing the risk that the Fed will need to cut policy rates faster and/or more deeply as labor markets soften and tariff-related inflation does not persist. Powell himself repeated again this week that the labor market is not a significant source of inflationary pressure. That means there is little argument for keeping policy rates at even “modestly restrictive” levels. Fed officials think neutral is about 125bp below current policy rate settings. Even after the full impact of tariffs in May, core PCE is likely to rise only by .14% MoM. What if the producers are unable to pass on the price increase to a already weak US consumer. What if some tariff impact is absorbed by the original supplier itself. The much-feared goods inflation is not happening at least till May. On employment front, Chair Powell mentioned the 4.2% unemployment rate six times in his press conference answers. But had it not been for the drop in the participation rate in May, the unemployment rate would stand closer to 4.6% and we continue to see risks skewed toward a rise in unemployment. The Fed game plan of a hold till they get further clarity of the tariff impact is shaped by it’s failure of understanding the not so transitory nature of inflation in 2021-2022. 3 months of benign core PCE readings with jump in continuing jobless claims should have been viewed otherwise if it had not been for Fed’s failure of understanding the inflation of 2021-2022. The current Fed is haunted by it’s failure on the peak inflation of 2021-2022 when Fed chair Powell continued to use the term transitory for almost 2 years before he understood it was not so transitory. The current wait & watch approach of Fed is almost close to a policy error and we won’t be surprised to see a 50-bps cut in Sep meeting just like last year’s 50 bps cut in Sep’24. We are looking for 275k nos in initial jobless claims by August & 4.5% UR by Aug NFP. Both July & Aug NFPs will be critical for our view to come correct.
