The dual mandate, the case and the outlook

As you know, I am not a market pundit and I do not commit to any macro views - not even my own, only to my trades, and only until stop-loss. For the rest, I try to judge context and, in terms of risk taking, I want to be in a position not to care about what happens, but make money nevertheless.

With today's payrolls numbers, 3mo average total payrolls went from 249K to 177K while 3mo average private is now 146K. We went from the green zone to the yellow zone, just like that, in part because of revisions. Employment went up in both the household and establishment survey, so, although the trend is clear, the rise in unemployment rate is less concerning to me because, with growing population and participation rate, this for now looks more like a slowing in hiring than an acceleration in layoffs. In any case, even barring a sharp deterioration in the labor market, which is always a possibility, things have for sure moderated there, and risk management in the dual mandate becomes more and more relevant. So where are we with inflation, what context may be relevant there?

If you recall, in June, the ECB cut the deposit rate and they did so on outlook. Meaning that core services inflation was still too strong, both in terms of YoY rate (4.1% as of May) and 3mo momentum (even higher), but the view was that with restrictive monetary policy the impulse in wages and unit labor costs would dissipate within the next year or so. This is a plausible stance, and furthermore, EU CPI is forgiving when it comes to core services inflation as the weight in the basket is much lower than in the USA (45% in the EU vs. 66% in the USA). Despite higher core services weight in the USA PCE basket, here monetary policy is also restrictive and unit labor costs have already normalized, so that has to count for something in terms of inflation outlook.

Why this is important? Because, due to the dual mandate, when the Fed will cut rates, maybe in September, they will need to make a case on outlook, as the ECB has already done, given that services inflation will plausibly not have normalized to the degree to make their case self-evident. The problem with core services inflation is that it has barely decreased on a YoY basis since December 2023 (from 4.0% to 3.9%) and has been way to high on a 3mo average basis (although decreasing to 3.6% in May 2024, but the same measure was 2.9% in December 2023).

PCE Core Services inflation is made of 3 components, roughly 25% housing, 25% health care, and 50% other services. Note how the monetary target is far heavier in other services, and health care, while CPI is more weighed towards housing, which is 60% of CPI core services. So what case can you make on PCE core services inflation, still stuck close to 4%, based on outlook? The case to be made is on other services as they drive PCE core services in good measure. Furthermore, health care inflation is already close to 3% (3.1% YoY as of May 2024, and generally less volatile), housing is much higher (5.5% YoY) but there the trend is down, and it is the usual argument of market rents, business cycle, and time-lags. It is the outlook for other core services that needs to be clarified, also because most of the stickiness in PCE core services comes from that.

One issue with other core services is that they are influenced by imputed costs, which are in part linked to labor costs. This is not the case for housing and health care, although lags are present there as well. Thus, it is interesting to see what other core services are doing if one takes away those imputed costs, and looks at market-based other core services instead. The rationale is clear. Market-prices are the real current impulse (there are nuances here, but bear with me), and if those are well or better behaved, then it is just a matter of time. Imputed costs are an intellectual construction and although part of the target, maybe it is good to take them out and see if we can see more clearly without. It may come as a relief to the Fed that market-based core other services have indeed unstuck already. With unit labor costs normalized and imputed costs dependent on those, this looks helpful and hopeful. Here we go, we have a case. Clearly, opinions may differ.

Keep an open mind. I see everybody joining one side or the other. There is comfort in numbers. But this is how I see things for now, and I think it helps to clarify what we should be talking about.