Tim Graf (TG): This is Street Signals, a weekly conversation about markets and macro brought to you by State Street Markets. I'm your host, Tim Graf, head of Macro Strategy for Europe. Each week we talk about the latest insights from our award winning research, as well as the current thinking from our strategists, traders, business leaders, clients and other experts from financial markets. If you listen to us and like what you're hearing, please subscribe. Leave us a good review, get in touch. It all helps us to improve what we offer. With that, here's what's on our minds this week.

Last week I introduced a few questions for markets to ponder as the summer holiday season kicked in. And it didn't take long for events to prove a very interesting test case, especially on the question I had of whether market sentiment will remain as robust as it has been in recent months. Data on weaker US Household consumption and big downward revisions to US labor market data highlighted this risk of whether equity sentiment can fully detach from what looks to be a pretty sharply slowing US economy. They also strike at the heart of another question I posed, which was whether tariff related inflation pressures will now ratchet up. So far, tariffs have definitely had an effect, but as my guest this week points out, the weaker demand data that I just highlighted, as well as a few other factors suggest that an acceleration of inflation from here is not a given. We take a deep dive on this topic and its implications with Michael Metcalfe, our global head of Macro Strategy.

Michael Metcalfe (MM): Morning Tim. How you doing?

TG: I'm good, how are you?

MM: Yeah, I'm hoping my voice is going to last. It's. Oh dear, it's a bit croaky. Have you got an app for that?

TG: Yeah, I'm not sure. We'll see.

MM: There must be. I feel like there must be one anyway.

TG: Coffee. Coffee always helps. Little day nurse. We can always edit out coughs. That's easy.

MM: Okay, there we go. I think I'm ready.

TG: Okay, well you're sounding a little bit better than when we started, which is good. I definitely want to get to the labor market because that was the big news last week, the big downward revisions to US payroll numbers. But last week's podcast I sort of introduced the topic of inflation and tariff related pass through to inflation market.

So to start with, can you just for the audience level set and kind of flesh out where we are right now in terms of whether we are or are not seeing tariff related pass through into US inflation?

MM: Yeah, and look, I think we're learning more by the day. The one thing I would start with, this sounds like A kind of fairly obvious point to start with but is that we are seeing pass through into certain sectors and certain goods and goods from certain countries.

And the reason why I just want to start with that rather obvious point is I think that there's been a kind of a narrative that companies kind of brought inventory in, in Q1, which of course we knew that they did, and then somehow sold that inventory on at lower prices without moving prices to reflect the tariffs. I think that that lag hasn't really occurred and I think that we, you know, across the sectors really since February, to be honest, as soon as we start to see some of the first tariffs come in, you know, we've seen certain goods and certain sectors move. So I think that there definitely has been passed through, it's been so far relatively modest. Modest is probably the right word. Goods from China are up about 3 percent as an example. So it's not that the entire tariff has been passed through, but we've definitely seen some pass through. And it's not that companies have been waiting to move prices. So tariffs are definitely having an impact on inflation.

TG: Would you say at this stage that the tariff related effects that we can track through price stats? Of course, this is where we get a lot of this information.

Are they at this stage accelerating or decelerating or is it just pretty consistent relative to what we've seen throughout that time period you talked about since, since February?

MM: So I think that that's why it's a really interesting time to talk about this right now actually is that the, the goods from China in particular had effectively gone up in a straight line since about March, you know, mid-February. And the one thing I should stress is this isn't the aggregate price stats data. This is a subset of five retailers Alberta Cavallo uses in his pricing lab paper where we have direct country of origins. It's narrow, but it's a detailed measure of import price inflation by country.

The interesting thing is that having gone up in a straight line up until about mid-June the last month, we've actually seen it hesitate a little bit and this is the first time this year we've actually seen on a month, on month basis prices of goods from China actually not go up. I'm going to hedge this a little bit because this is not seasonally adjusted data and clothing prices in particular typically go down a lot at this time of year. So it might just be seasonals. But that, that, that read over the last month would seem to suggest that the, the import price pass through from goods from China and other countries as well actually seem to have paused in July.

TG: You mentioned the China series and the negotiations with China are still ongoing. Effectively they've been kind of punted down the road another few months. We probably won't know a certainty what any of the tariff schedule looks like given how volatile it has been so far. I mean we have better ideas of what some elements will be though because we have agreements with Japan, the EU, Korea, a lot of other countries, the UK as another one. There's an expectation forming around what the aggregate average tariff level will look like. Something along the lines of say 15, maybe as high as 18 percent once we get China sorted out.

Do you have a sense of how retailers will behave now going forward? Have they incorporated the largest elements, I guess of tariffs or have they been waiting to see, to get this clarity, to see what the average tariff rate might be? Do you have a sense of what this tariff related pass through effect might now be and any thinking on that?

MM: Where the effective tariff rate is likely to land has been highly volatile. I think at various points it looked like it might be as high as, well, goodness, I think at one point it might have even been at 30 percent potentially. So the fact that we are gradually removing the uncertainty of where it's going to land is going to be very helpful for retailers. But the curious thing, if it does land in that kind of 15 to 18 percent range, it throws us back to, you know, the original papers that were done on this by Alberto Cavallo and actually to be fair, the fed back in 2018, just starting with Alberto's paper, his, his conclusion in the first round of tariffs was that tariffs that were below 20 percent tended to get more absorbed in margins than passed through. You know, these tariffs are slightly different.

There's a much more permanent angle to these which you know, might increase the chances of more pass through. You know, there's still this takeaway that there might not be quite as much inflation as we, as we fear. And then going down to the Fed paper so that, you know, the Fed's teal book did a study of a 15 percent universal tariff. Now obviously that isn't what we've got in, in, in, in 2025, but it's maybe not as far off as we thought it was going to be. And it's just interesting that their study found that, you know, you would get passed through in the first year into core PCE, which I think is obviously what we're currently forecasting or you know, what the street is forecasting for 2025 going into 2026, but that you would also get a recession, particularly you would get a recession if the Fed hiked rates in response to it.

So if we do land in this 15 to 18 percent effective tariff rate, I think we're going back to some of the original studies that we thought back in November as to, you know, what the outlook for tariffs was going to be because we've removed some of the more disastrous, much higher effective tariff rates, which it looked like we might land at various points in the last four or five months.

TG: Yeah, well, I have a final question on this before we start to talk about the labor market. Actually I wanted a question just came into my mind based on what you said as to whether the Fed will respond by hiking rates. Let's park for a moment. But before we get to all of those things, of course the inflationary experience in the official data has been a lot more benign. And to be fair, we have actually forecast this in our price stats forecast series where we've seen downside surprises, particularly on headline CPI over the last few months.

What effects have mitigated the tariff related inflation pass through that we have been talking about the last ten minutes or so.

What has created this more benign, at least benign to date environment for inflation?

MM: Yeah, I mean I think the key point you made there is to date, but there are bits of it I think which continue throughout the year. And we've talked an awful lot about housing and rental inflation and new rents and the last set of new rental data. That data does get revised up to be fair. But the last set of new rental data was basically suggesting that housing inflation is done. Housing inflation has been a big part of why inflation and core inflation has been sticky. So I think that's been a really helpful offset. But there's also been, I think in addition to that, much lower energy prices had helped and obviously they've stopped helping.

And I don't have the forecast yet for July, but you know, we've kind of got this slight juxtaposition right now whereby import price inflation looks like it's beginning to roll over. However that's happening just at the point where, you know, actually the inflationary process does seem to be broadening a bit and just taking it kind of at the headline level. PriceStats is much stronger than it normally is in July and it looks to be much broader. And Alberto actually again going back to some of his other work on trend breaks across components of core CPI, that work is now detecting a much broader inflationary process underway.

So you know it might be that the impulse from tariffs runs out just in time, just as the broader inflationary process is taking off. The one offset that remains, even if energy doesn't, is housing. I think that is still a very, kind of a very solid and helpful disinflationary trend which will at least partially offset the impact from tariffs.

TG: Okay, well I want to now shift to a potential disinflationary trend that has not happened, but isn't as positive a factor. Yes, and that is the labor market. And so, just as background for people listening, last Friday we got the usual monthly update to non-farm payroll data.

And it wasn't so much the headline that caused waves, it was the revisions to the past two months that had previously beat expectations, looked relatively healthy, defying expectations that this whole trade war dynamic and the uncertainty created was maybe not as bad.

But of course now with the revisions, we know that really over the last three months there has been minimal payroll growth in the US but this is not the only indicator of the labor market and a lot of them still look okay.

And I'm thinking here, particularly about the weekly jobless claims data, the unemployment rate. The Fed is focused squarely on this. Actually they've brought this up a couple of times and Powell did in his press conference last week, I think, refer to it time and again, that the unemployment rate is still pretty conducive to an economy at full employment.

How do you square these numbers and these revisions that look so negative last week with other maybe more benign pieces of data before we get into what it all means for inflation?

MM: It’s not uncommon for payrolls to be revised and to be revised quite substantially, but there are revisions and there are revisions and these were much larger than we're used to.

I think it becomes very difficult for the market to, to price and react to payrolls when the actual release is something like a one stand error, upside surprise and then the revision is a five stand error move on the downside and the stand errors there being the spread of the economic forecast.

So I think it becomes very difficult and I think it highlights something that we've been worried about for a fair while, which is the response rate on the initial releases is poor. It's not quite as poor as where the UK got to when it suspended its series. But you know, below 50 percent is, is, is clearly a problem. I mean, obviously the reason why the unemployment rate doesn't move quite as much is that you've also got these swings around in labor supply and this kind of potential idea that some of the administration's immigration policies are going to lead to a shrinkage in labor supply. And so you've got reduced labor demand, reduced labor supply and the labor market somehow remains in balance. But I think the thing that it doesn't take away is that the, the cyclical single signal from labor demand is softening quite significantly and is also much weaker than we thought. That that makes it very difficult for markets and the Fed to kind of just you know, calibrate both prices and, and interest rates.

TG: Yeah, so it's the, basically the Phillips curve elements are in conflict with themselves which to be fair, Powell has talked about over the last year as being this, this problem they have not least given especially of late. You have tariff related inflationary pressures and we have evidence potentially that foreign born workers are leaving the labor force. But it's keeping, if that, if that is the case and keeping the unemployment rate steady and keeping the economy at what is close to full employment levels.

Does the potential for wage growth, does that worry you from the inflationary impulse angle at all and add to any potential tariff related pressures?

MM: The one thing that gives me some comfort, and it's a very similar argument actually to the housing inflation argument where you're looking at the kind of, you're looking at new rents on wages. I really like the indeed series on posted new wages. So this is the, the wage growth of the effectively in job adverts. So it tells you where wage growth in theory is headed.

And it's got a really nice kind of nine lead against the Atlanta Fed wage growth tracker at which it's kind of the indeed data is also composition adjusted there to match that.

I mean right now the annual wage inflation of new wages is below 3 percent. And this is an aggregate. So you know, this might occur in pockets in certain sectors obviously, but in aggregate what that tells me is that yes, there might be issues about labor supply, but if there was a real labor shortage then you'd have to try and get workers in, in your job ads.

You'd have a much higher wage inflation coming from that data set and you're simply not seeing it yet.

Obviously you may well see it further down the line, but we don't see it yet. And so it doesn't look like there's a labor supply driven rise in wages going on in aggregate at least we have these media stats, narrative indicators that track things like labor shortages.

TG: Actually, do you know what that coverage level of labor shortages look like? I know we tracked this a lot during the pandemic and in the aftermath And I think we still do look at it from time to time.

Do you have a sense of whether that corroborates any, any better news on labor shortages?

MM: We're looking at it both ways and it had this really interesting, so you know, looking at sort of mentions of worker hiring versus worker layoffs and shortages, it had this really interesting spike, you know, around February and March this year where there was a, you know, a lot of concern about layoffs which I think was primarily related to the news narrative around Doge and that kind of thing and about the, you know, the layoffs of government workers primarily.

But then since then it's normalized and actually the, the interesting thing I think with the media data is that quite similar to the other metrics I suppose is that it does show that the labor market is somewhat in balance. We, we haven't got a massive rise in layoffs, we haven't got a massive rise in hiring, nor have we got a massive rise in, in, in, in, in shortages. It's all fairly contained. And I think that would be in line with what the, what most of the Fed speaker narrative is. You know, they're talking about the labor market being imbalance.

The lesson from payrolls and with the revisions is that you know, it may well be in balance but it's sort of balance can also be stagnating and you know, so there's just really not much going on in the labor market I think is what we're currently capturing, which given this concern about shortages and inflation threat from the labor market that doesn't seem to be going on. 

The unemployment rate on its own would seem to suggest the labor market is much tighter. But many other indicators suggest actually that it isn't that tight and actually it's quite balanced.

TG: Yeah, well that's one thing I wanted to pick up on. People talk about labor supply dynamics keeping wage pressures high, tight labor markets as you mentioned, the unemployment rate suggests we have a tight labor market. A lot of other metrics do not. And I'm just curious if you have any thoughts on supply side inflation pressure that might creep in if the labor market continues to look this tight versus the demand side effects. We have people leaving the labor force as you've talked about, and particularly whether by choice or otherwise, we have surveyed measures of foreign born workers potentially showing them leaving the labor force.

Does the demand potentially going away and weakening, does that in your view offset any supply side pressures that come again from them not being in the labor force?

MM: You know, if you read through from the household survey that the labor force, the foreign born labor force is shrinking and therefore, you know, actually maybe the whole, you, maybe you're getting net migration out of the United States right now. And but here's the thing. I mean obviously we're, you know, we're questioning the establishment survey and after the revisions I wonder actually whether we'll begin to also question the household survey at some point along similar lines.

Is that, is that, is that actually a sampling era? Do we have any hard data that suggests that that is actually what's happening in terms of actually people leaving? I understand that there's good data on border instance and that kind of thing that would suggest that the flow of migration in is weakening. But then there's also a broader point I think where we do have hard data which is actually on consumer demand. Consumer demand has been very volatile this year, understandably, but it's generally been stronger than most of the consumer sentiment measures. But I think you're just beginning to now. So last week it wasn't really just about payrolls for me. It was also a little bit about the PCE and personal income reports which is that personal incomes for the last three or four months have been quite soft, at least ex transfers.

Personal consumption spending was also quite soft and you saw that in the GDP report, certainly softer than last year. So not saying that the consumers rolled over completely, but you've got much weaker income growth, you've got weaker consumption growth. And then here's the real puzzle. If you look at the kind of the, are the six indicators and it's not that formula. If you look at the six indicators that the NBER looks at, it's employment growth, it's payroll growth, it's both of the, it's the two things on PCE.

So it's income, personal income growth and personal consumption and then a bit of wholesale trade and IP, five out of the six are currently trending lower. That's a little bit of a concern. So I think you're trying to get to this kind of question about end demand and recession risk and that kind of stuff. And actually I, you know, just, just looking at those indicators that the NVR looks at, you know, it actually looks like the picture is softening quite quickly.

TG: Okay, you've, you've, I think you've answered what will be my capstone question for all this. But I wanted to, I promised I would do this. I wanted to take it back to the Fed and, and specifically in light of the work you cited, the teal book from 2018, the notion of responding to a 15 percent tariff rate increase with an interest rate hike. You know, we've talked in the intervening 20 minutes or so since then about a lot of things that would suggest otherwise and so forget about a hike. Fed policy as by their own definitions is still restrictive, it's still above neutral and is some distance above neutral.

How do you think they, they balance this in their messaging particularly? We're going to talk to Marv Lowe in a couple of weeks about the Jackson Hole symposium. Do you think at this point inflation expectations, which are kind of driving why they have not eased policy this year, is there a chance of them dancing more to the downside than the upside at this point? How do you think they're thinking about this?

MM: They're in an incredibly difficult position in the sense that the thing that's the big difference between 2018 and now of course is that they've, they had that kind of policy issue with transitory where they accommodated when they shouldn't have done. And I think they're just desperate not to make the same mistake again. And so that's why the 2025, 2026 outlook is more complicated for them. That said, past analysis would really quite strongly suggest that they should be accommodating and that the tariffs will be a one off shock to inflation.

There are tentative signs that inflation process is broadening out, but at the same time the broader economy is softening. And so it's not obvious to me that that really pushes through for much longer because there shouldn't be much pricing power in an economy where the consumer is rolling over a little bit and the labor market is balanced to deteriorate. Most importantly, obviously you asked about expectations. I think the hard thing, obviously consumer expectations now have become political and difficult to measure. Market based inflation expectations have gone up a little bit, but aren't too troubling for them. So I think on expectations they get a bit of a passion.

And once you're through the one off impact of tariffs, it's at that point inflation expectations probably begin to come down. Once you've got that effective tariff rate locked in and all that kind of stuff which we obviously we touched on, but you're just not quite there yet. You can't be completely confident that because the tariff news has been so volatile, you can't say with a really high degree of certainty that we're kind of through the worst just yet. We need to get the Chinese tariffs locked in and once they're locked in and maybe we'll be able to move on and think about longer term Inflation expectations coming down. The impact of labor supply obviously will be a massive topic in Jackson Hole. It'll be difficult to see how they communicate that, because to some degree there's very little the Fed can do.

Monetary policy can't impact labor supply to any meaningful degree. All it can do is deal with the consequences of it. And so that's why I think that new wage growth from indeed is key. Because as long as that remains benign, the Fed shouldn't be worried about labor supply. So it's almost like these two new series. The series on new rents tells them that they shouldn't be worried about sticky inflation from the housing market, and the new wage series tells the Fed they shouldn't be too worried about the impact of labor supply on wage growth.

TG: Fair enough. I'm worried about the impact of this podcast on your voice, so I'm going to let you go. You've been very generous with your time. We've pushed things to the limit, I think, but it's all been very interesting and of course, as you know, we'll wait and see and we'll talk to Marvin a couple of weeks about the Fed in a bit more in depth. But for now, Michael, thanks so much for joining this week.

MM: Yeah, pleasure. Thanks Tim.

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