FOMC Preview and Global manufacturing PMIs/bottlenecks

FOMC Preview: Upside inflation surprise risks 75bp hike

This coming Wednesday, we expect the Fed to deliver its second 50bp rate hike, taking the target range for the fed funds rate to 1.25-1.50%. However, we also see a significant risk that the Fed makes an even bigger move in rates of 75bp, given the upside surprise in the May CPI reading on Friday. While the inflation surprise was concentrated in food and energy prices, the strength in the data was broadbased, with continued – and worrying – firmness in services inflation. Following the reading, we have raised our headline inflation forecast for 2022 by another percentage point, to 9.0% from 8.0% previously, and expect more of this strength to carry over into 2023, with inflation expected to average 4.6% (previously 4.1%). As flagged in our Fed call change last week, we expect month-on-month inflation readings to remain far above the Fed’s target over the coming months, and somewhat above target later in the year, and this should keep the Fed hiking at a 50bp pace for all remaining meetings of 2022, and likely once more in 2023.

Focus on rate guidance as well as size of the June hike

Indeed, the upside surprise in the May inflation data gives us stronger conviction in our call for the Fed. We expect the upper bound of the fed funds rate to peak at 4% by February, which is well above the consensus forecast of c.3.2% according to Bloomberg. The Fed’s quarterly update to its macro and rates projections on Wednesday should drive a further move higher in consensus expectations. Although it is uncertain just how far the Committee might go with this signalling, we suspect the median projected peak in the fed funds rate will fall somewhat short of our expectation of 4%, but be well above the current consensus expectation, i.e. perhaps signalling an upper bound of 3.75%. Should the Committee deliver a 75bp hike at this meeting, it is possible that its projected peak might be even higher than our new base case.

At the press conference, meanwhile, we expect Chair Powell to continue to be incrementally more hawkish in the face of the mounting inflation challenge, perhaps flagging the risk to markets that the Fed has to move even more aggressively than the June projections might suggest. We also expect him to continue to emphasise the priority the Fed places on achieving price stability, even if this comes at the expense of a near-term rise in unemployment. The Fed will want to ensure there is no doubt among market participants over its resolve to fight inflation. So far at least, the Fed appears to have maintained this credibility in markets, with 5y5y breakeven inflation still hovering around 2.7%, despite the successive upside surprises to inflation over the past year.

Global Macro: Global manufacturing PMI stabilises in May…

After having dropped significantly in March and April following the war in Ukraine and the broadening of Chinese lockdowns, the global manufacturing PMI stabilised in May at 52.4 (April: 52.3). That was largely driven by the recovering of activity in China, following a broadening of lockdowns in March and April. China’s manufacturing PMIs showed a clear rebound in May, although remaining below the neutral 50 mark separating expansion from contraction (also see our comments here). This drove up the aggregated index for emerging economies back to 49.5 (April: 48.1). Meanwhile, the index for developed economies dropped to 55.0 (April: 56.3), although staying at relatively robust levels. We should add that still lengthy (although improving) delivery times are to a certain extent flattering these numbers.

…helped by improvements on the supply side

Looking at the various subcomponents, the stabilisation of the global manufacturing PMI in May was mainly supported by developments on the supply side. China’s gradually reopening drove the global output component a full point higher, to 49.7. The subindex for delivery times also improved in May, to a three-month high of 38.9. The delivery times’ component for developed economies rose by 2.6 points to 32.9, and is now 8.5 points above its trough reached in October 2021, albeit still at relatively low levels from a historic perspective. At the demand side, the global sub-index for domestic orders improved by 0.4 point to 50.9 (April: 50.5), also driven by China. However, the equivalent for developed economies dropped by two points to a 21-month low of 52.4. Moreover, the global sub-index for export orders dropped deeper in contraction territory, to 47.9, with both the aggregated sub-indices for developed and emerging economies now below the neutral 50 mark. To conclude, the sub-indices for input and output prices – a measure for the severity of global cost push pressures – came down somewhat in May. Still, these sub-indices remain at historically high levels, largely driven by commodity prices.

Our global supply bottlenecks index shows a modest improvement

All of this is also illustrated by a modest improvement in our global supply bottlenecks index in May. That is mainly driven by a sharp rebound in the EM output versus DM orders ratio, but also by some improvement in the delivery times for electronic equipment. Looking ahead, assuming a gradual fading out of pandemic-related supply disturbances and a further cooling of demand for goods in developed economies (as we do in our base case), the fading of global supply-demand imbalances in goods should have further to go. That said, this index does not capture shocks and (price) volatility in specific commodity markets, nor domestic supply issues such as scarcity on labour markets or congestion in specific ports.

What are the risks from renewed Covid-19 restrictions in China?

In our base case we assume a gradual reopening in China from the lockdowns in March/April, although this will not be a clean process without hiccups given the ongoing strict Covid-19 policies in the country. This was illustrated by a recent tightening of measures in megacities such as Shanghai (with a short lockdown on Saturday to facilitate mass testing) and Beijing, following an increase in the number of reported cases. Within China’s dynamic clearing framework, the idea is to detect cases at an earlier stage, to prevent longer lasting city-wide lockdowns such as in March and April. While the renewed restrictions will obviously affect Shanghai and Beijing residents and may well delay the recovery in consumption further, so far it looks they are less disruptive to production and transport compared to March/April, also reflecting a host of government measures taken to restore production and transport facilities after the previous wave of lockdowns. All in all, as uncertainty regarding pandemic developments in China and Covid-19 policy remains high, with risks still tilted to the downside, we have looked at alternative scenarios as well (see our May Global Monthly here). In a negative scenario, Omicron flare-ups in China combined with ongoing strict Covid-19 policies result in the overall lockdown intensity staying at relatively high levels, with obviously negative consequences for Chinese GDP growth and global supply chains.