Why Deutsche thinks a Fed policy terminal rate of 5% is appropriate

WHY DEUTSCHE THINKS A FED POLICY TERMINAL RATE OF 5% IS APPROPRIATE (1235 EDT/1535 GMT)

A 5% terminal rate, or the peak for the Federal Reserve's fed funds rate, may be required to bring inflation down, according to analysts from Deutsche Bank led by chief U.S. economist Matthew Luzzetti.

The current fed funds rate is 2.33%, following a 75 basis-point hike in July.

Deutsche presents two approaches on calculating the terminal rate, comparing the nominal fed funds rate and a slew of common policy rules. Both suggest that a fed funds rate at or above 4.5% is likely to be required by early next year.

However, taking into account risk management, a rate near 5% is more likely to be appropriate, Deutsche says. The bank now sees the Fed's policy rate peaking at 4.9% in the first quarter of 2023.

One benchmark for how high the fed funds rate might need to rise to ensure sufficient tightening is to have it exceed spot year-over-year inflation, Deutsche says. Historically, this has always been met in every tightening cycle, regardless of whether inflation was high as in the 1970s, or low like during the last cycle.

The recent upgrade to Deutsche's inflation forecast has important implications for the appropriate peak fed funds rate. The German bank see U.S. annual core PCE inflation staying above 4.5% through year-end and into early 2023, noting that the terminal fed funds rate would need to exceed these levels.

Deutsche then sees core PCE inflation declining to around 4.1% by mid-2023. After accounting for a slightly positive real neutral rate, a terminal rate above 4.5% is likely to be necessary.

That said, continued upside surprises in core PCE could lead to a peak fed funds rate exceeding 5%, Deutsche says, particularly if it happens along with easier financial conditions and a tight labor market.

On the flipside, a faster slide in inflation coupled with tighter financial conditions and loosening in the labor market, could see a terminal rate closer to 4%.

"At this point, we see the risks skewed in the hawkish direction," says Deutsche.

(Gertrude Chavez-Dreyfuss)

THURSDAY DATA STORM: FEELING FOR THE FED EFFECT (1121 EDT/1421 GMT)

A maelstrom of data engulfed market participants on Thursday, providing a many-faceted glimpse regarding U.S. economic health as the effects of the Federal Reserve's aggressive inflation-taming tactics slowly begin to make themselves felt.

Receipts at U.S. retailers unexpectedly rose 0.3% in August in a partial reversal of July's downwardly revised 0.4% drop, according to the Commerce Department.

Analysts expected no change.

Car sales boosted the headline; excluding autos, retail sales dropped 0.3%

Line-by-line, receipts at gasoline stations plunged 4.2% owing to lower prices at the pump - without which the topline would show an 0.8% gain. Non-store retail, which includes e-commerce, dropped 0.7% but food and drink services grew by a healthy 1.1%.

"The drop in gasoline sales was much smaller than the 10.6% plunge in prices, indicating that people drove more as prices fell," writes Ian Shepherdson, chief economist at Pantheon Economics.

"This is a mixed report, but we see no cause for alarm," Shepherdson adds. "With real incomes likely to rise at a 6% annualized rate in Q3 ... retailers have little to fear."

Inflation remains a top concern in survey data, and consumers are increasingly dipping into savings and whipping out there plastic to cover their spending. But for now, at least, they're spending.

So-called "core" retail sales, which strips out autos, gasoline, building materials and food services, a measure that closely tracks the personal consumption component of GDP, surprised to the downside by holding steady after rising by 0.4% in July.

The consumer, who contributes about 70% of the U.S. economy, continues to be supported by a robust labor market, at least for now.

The number of U.S. workers filing first-time applications for unemployment benefits edged down to 213,000 last week, according to the Labor Department.

But employment, of course, is a lagging indicator. And the delayed effects of the Fed's aggressive tightening are likely to begin showing up in labor market data in the months ahead.

Even so, the sector is tight; despite some signs of loosening, there remain about unfilled positions for every unemployed American.

"The supply and demand for labor continue to be out of balance," says Nancy Vanden Houten, lead U.S. economist at Oxford Economics (OE). "We look for employers to continue to slow the pace of hiring workers well in advance of any significant layoffs, which we don't anticipate until next year."

Ongoing claims, reported on a one-month lag, were essentially unchanged at 1.403 million.

The Federal Reserve contributed to the "glass half-empty" column with its industrial output, which surprised to the downside by falling 0.2%.

Analysts expected a nominal 0.1% growth.

Capacity utilization, a measure of economic slack, slackened by easing to an even 80% instead of holding steady at 80.3% as economists predicted.

"Momentum in factory activity has slowed so far in Q3," says Rubeela Farooqi, chief U.S. economist at High Frequency Economics. "Supply chain constraints and price pressures appear to be easing, which is a positive for manufacturing."

"But factory activity is likely to moderate in response to slowing demand amid a rising interest rate backdrop."

Factory activity? Funny you should mention it.

Two reports on that subject relating to the Atlantic region showed the manufacturing sector contracted in New York and Pennsylvania.

The Federal Reserve banks of New York and Philadelphia bucked tradition by releasing their Empire State and Philly Fed numbers on the same day.

And they both showed a drop in activity this month.

The Empire State figure landed at -1.5, a solid improvement from August's -31.3 plunge, while the Philly Fed defied expectations by sinking to a reading of -9.9 from the prior month's 6.2 print.

An Empire State/Philly Fed number below zero signifies a decrease in monthly factory activity.

In the case of the Philly Fed, the pain of a sharp deceleration in new orders was eased by a welcome plunge in the prices paid component, another encouraging sign of an inflation cool-down.

"For manufacturing, a gradual easing of prices pressures and supply chain disruptions is a positive," Farooqi adds. "But softening demand as the Fed continues to hike rates is a downside risk for activity in the sector going forward."

While the two indexes often disagree, moving in opposite directions on a given month, they do follow the same broad arc, as shown here:

Next, some good inflation news to chase Tuesday's dire CPI report and Wednesday's inline PPI data - prices of goods and services imported to the United States posted a welcome 1% monthly drop last month.

On an annual basis, import prices cooled substantially to 7.8% from 8.7%.

A jumbo 7.1% slide in petroleum and a sizeable 2.9% drop in industrial supplies were two major factors behind the decline.

"While yesterday's PPI report and today's import prices are encouraging, they are not enough to offset the broad-based CPI report earlier in the week," writes Matthew Martin, U.S. economist at OE, adding that the Fed is "on track to raise rates 75bps next week and at least another 75bps by year end."

While still hot, that brings it inline with other indicators, all of which, though trending downward, continue to soar well above Powell & Co's average annual 2% inflation target:

Finally, the merchandise stacked in the storerooms of U.S. businesses grew by 0.6% in July, according to the Commerce Department.

The number hit the consensus nail on the head and represents an expected deceleration from June's more robust 1.4% gain.

Still, business inventories have notched 13 consecutive months of gains, a trend that suggests the global supply chain is gradually untangling itself.

It also bodes well for U.S. economic growth. The private inventories element has been a net detractor of GDP so far this year:

Wall Street was trending red in late morning trading as investors stare down the Powell posse, expected to kick up dust and anxiety as it rides into town next week for a fresh round of interest rate hikes.

U.S. STOCKS EDGE UP IN EARLY TRADE (0952 EDT/1352 GMT)

After opening modestly lower, major U.S. stock indexes have moved slightly higher on Thursday, as a flurry of economic data did little to derail expectations the U.S. Federal Reserve will remain aggressive in its fight against high inflation.

Weekly initial jobless claims fell indicating the labor market remains strong, while retail sales for August unexpectedly climbed, as falling gasoline prices helped lift spending, though demand is cooling.

Still, in signs of a slowing economy, gauges of manufacturing in the mid-Atlantic region and New York for September were lower than expected, while industrial production for August was also lighter than forecast.

Markets are completely pricing in a rate hike of at least 75 basis points by the Fed at its policy meeting next week, with a 20% chance of an outsized 100 basis point hike, according to CME's FedWatch Tool https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html?redirect=/trading/interest-rates/fed-funds.html.

Energy is the weakest of the 11 major S&P sectors, with crude prices down about 3% on demand worries while financials are leading the way higher.

Below is your early market snapshot:

(Chuck Mikolajczak)

NO ROOM FOR DOUBT! BERENBERG SEES HOTELS AS TOP TRAVEL PLAY (0920 EDT/1320 GMT)

After a rough two years, Berenberg says the suffering might finally be over for the leisure industry, picking hotels as its top travel play.

The brokerage says concerns about the hotel industry are overblown and that the outlook for revenue per available room (RevPAR) for 2023 and 2024 will strengthen further.

Berenberg says there is no evidence of bigger structural risk to either business travel and anything pointing to a migration to disruptors like Airbnb Inc and other online travel agencies (OTAs).

It raises its ratings on Hilton, Hyatt and Marriott to "buy", and even with the threat of a recession moving into 2023, the pace of recovery in the hotels industry means is significant enough for a strong RevPAR increases in 2023, and that this is not being fairly reflected in the share prices.

(Johann M. Cherian and Shreyashi Sanyal)

YEN INTERVENTION IMMINENT? BCA SAYS PROBABLY NOT (0900 EDT/1300 GMT)

Investors in the nearly $7-trillion currency market are on tenterhooks as to whether the Ministry of Finance through the Bank of Japan will actually deliver on its warning to intervene in the market to boost the weak yen.

On Wednesday, the BoJ conducted a rate check with banks on Wednesday in apparent preparation to step in to tame sharp yen falls. Finance Minister Shunichi Suzuki said authorities would make no advance announcement of plans to intervene, and usually would not confirm they had stepped into the market after doing so.

BCA Research joins a chorus of analysts who believes that Japanese authorities are unlikely to step in.

In its latest research note, the Montreal-based firm writes that "while sharp moves in the yen are unfavorable, policymakers will only respond if currency weakness is seen as impacting broader macroeconomic conditions."

In this case, it noted that a weak yen typically puts upward pressure on domestic inflation by increasing both import prices and yen-denominated overseas earnings.

But BCA says inflationary pressures remain relatively tame in Japan. The headline index grew 2.6% year-on-year in July -- significantly lower than other developed market economies where inflation rates are closer to double digits.

In addition, the index excluding fresh food and energy grew just 1.2% year-on-year in July - below the central bank's 2% target.

BCA's FX strategists recently estimated that the yen needs to weaken by 10% a year to generate a one percentage point increase in Japanese inflation.

"Ultimately, these dynamics suggest that while policymakers may attempt to jawbone the yen, they are unlikely to rush to support the currency."

The dollar was last up 0.1% at 143.43 yen.

(Gertrude Chavez-Dreyfuss)

(Reporting by Gertrude Chavez-Dreyfuss)

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