Viewpoint
May 15, 2026 | 14:36
U.S. Firing on All Cylinders—Inflation Too
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
U.S. Firing on All Cylinders—Inflation Too |
| The economy has largely shaken off the doom and gloom of rapidly rising gasoline prices, at least for now. The steady stream of better-than-expected economic reports continued in earnest this week, topped off by solid core retail sales growth of 0.5% for April and a sizeable pick-up in manufacturing growth of 0.6%. Capturing that resilience in one measure is the Bloomberg Economic Surprise Index that firmed to a positive 41 this week, as economic forecasters have largely underestimated the extent of the growth momentum in recent weeks (Chart 1). Economic indicators haven’t beaten forecasts this consistently since September 2023, according to this index. |
| In short, the economy continues to fire on all cylinders as business equipment spending jumps on AI investments and as higher-income households continue to spend a portion of their wealth gains in stores. Production of business equipment and computers/office equipment both soared 1.5% last month, while motor vehicle production ramped up with a strong 3.7% increase. April was the best month for manufacturing production since February 2025—a remarkable feat given that we are mired in the worst global oil production shock in history (Chart 2). A major driver of that economic momentum is a consumer that, despite proclaiming the worst sentiment in history, continues to keep pace with rising prices and then some. The retail sales report was topped off by solid upward revisions in the control group for February and March, and a better-than-expected print for April. Control group retail sales exclude volatile categories such as motor vehicles, building materials, gas station, and food service sales, and are used to help forecast real consumer spending in the GDP report. This measure has increased an average 9.2% a.r. over the past three months, suggesting consumers are still spending faster than inflation, even as the latter devours more of their future spending power (Chart 3). Based on these figures, we raised our call for real consumer spending growth in Q2 by two tenths to 1.8%. Indeed, we believe consumers actually boosted their real spending in Q2 compared to the first three months of the year. A number of well-documented drivers are behind this performance: record-high household wealth and stock prices; household balance sheets that are generally in very good shape; debt service burdens that remain below pre-pandemic levels; a labor market that remains in balance and may even be firming. Inflation fears may even be motivating some consumers to spend more on big-ticket items like appliances and cars today, before prices rise even further. Of course, this consumer resilience can’t go on forever, and something will have to give if the Strait of Hormuz doesn’t open and inflation and interest rates continue to surge. The downside of all this economic resilience is a Fed that may have to stay restrictive—or even become more restrictive—to rein in inflation. The probability of a Fed rate hike continues to rise in financial markets (now around 60% by the end of the year) with the 10-year Treasury yield this week surging to 4.57%, up 63 basis points since the war started. Kevin Warsh will have to prove to markets he has the right stuff to solve the Fed’s inflation problem before entertaining further rate cuts. |
Warsh’s Welcome Wagon |
| May 15 marks the final day with Jay Powell as Fed Chair. Kevin Warsh’s four-year term starts the next day, when he will take over the Board of Governors seat vacated by Stephen Miran. His first FOMC meeting as Chair will be June 16-17, exactly a month after assuming the role. The market is already speculating about that first meeting, let alone subsequent confabs. Stoking the speculation are: (1) last meeting’s more hawkish-leaning dissents and Powell’s announcement that he’s staying on for a bit; (2) the tone of subsequent data that highlighted both core CPI and PPI inflation heating up more than expected and payrolls growth surprising again to the upside; and, (3) Warsh’s reported preference for lower policy rates and his “regime change” agenda. The FOMC kept rates unchanged last month, with the target range for fed funds at 3.50% to 3.75%. This was the third straight pause after three consecutive 25 bp cuts during the final three meetings of 2025. Governor Miran dissented for the sixth straight time (covering his entire tenure) in favor of a rate cut (or a larger one). The market is questioning whether Warsh will follow Miran’s dovish wing prints. At this point, we do not think so (at least not at Warsh’s first confab as Fed head), given the Chair’s traditional role in crafting and communicating the Committee’s consensus. The Fed also kept its forward guidance unchanged with the phrase: “In considering the extent and timing of additional adjustments to the target range for the federal funds rate…” Toggling in and out the “the extent and timing of” modification, this is the language used since rate cuts began in September 2024. Whenever the modification has been absent, it has signaled a cut next meeting (Sept./Nov. 2024; Sept./Oct. 2025). Otherwise, it has signaled a cut as early as next meeting or after a pause. This ‘easing bias’ has become problematic for some FOMC participants. Three voters (and likely other non-voters) favored altering the language and dissented accordingly. Cleveland President Hammack, Minneapolis’ Kashkari, and Dallas’ Logan supported the pause “but did not support inclusion of an easing bias in the statement at this time”. Given the increased risk of faster inflation from the oil shock (with the labor market stabilizing in the background), they preferred a more neutral statement to convey that rate cuts were no more likely than rate hikes. There is still a full month of new data to go, but if the tone of recent reports persists, we reckon the ranks of the ‘neutralists’ will be increasing in June. There is the chance that at least four more voters (among the remaining nine) will join April’s trio and the easing bias could be dropped. The market is questioning whether Warsh will be onside should the majority favor shifting policy further away from potential easing, at least for a little while, and towards possible tightening. Elsewhere, it is going to take time to tick off the assorted items on Warsh’s “regime change” agenda. In some cases, he will need congressional action. For example, to meaningfully shrink the Fed’s balance sheet, legislation is required to relax bank liquidity rules (the liquidity is often in the form of reserve balances that currently top $3 trillion, and boost the balance sheet’s size). And, when the Fed does not “stay in its lane” (of promoting price stability and maximum employment), it is often because Congress has given the Fed authority over regulatory and supervisory matters. In other cases, Warsh will need majorities on the Board of Governors or in the FOMC to effect change. Providing less forward guidance (via modifying or dropping the ‘dot plot’ or having fewer pressers) or altering the operational target for inflation (using the trimmed mean and median indices instead of the core) are monetary policy practices that are voted on (just like rate decisions). To walk his nomination hearing talk, Kevin Warsh must convince other Governors and regional Presidents to hop on his bandwagon. This will take time, but at least he has Jay Powell’s counsel for now. Bottom Line: Despite the arrival of a new Fed head, we are modifying our forecast for policy rates. We still see the midpoint of the target range down 50 bps to 3.125% over time so that it aligns with the FOMC’s median projection of the neutral level. However, given last month’s dissents and the tone of subsequent data, we now judge that the move to neutral will be delayed by three months, to December-March. |
Why Are Crude Oil Prices Not Higher? |
| It’s a question that we are often asked given that the oil market is facing one of its biggest supply shocks in history. It’s also a fair one considering the Strait of Hormuz has been effectively closed for two-and-a-half months, disrupting 20 mb/d of crude oil and oil products that were previously shipped through the Strait. This equates to around 25% of the world’s seaborne oil trade. Such numbers explain why so many observers are of the view that benchmark prices are still too low. However, it appears that there are key offsetting factors suppressing upside pressure. First off, we think it’s important to break down the 20 mb/d figure into two separate/distinct product groups before we focus on the main offsets. Three-quarters of this amount is crude oil, while refined products make up the rest. Thus, the true gap that needs to be replaced is 15 mb/d. A big chunk of this has been accomplished by diverting crude oil through two key pipelines. Usage of Saudi Arabia’s East-West pipeline has reportedly increased by 5.3 mb/d, while UAE’s Habshan-Fujairah pipeline is transporting an additional 800 kb/d. This means that the rest of the world needs to cover another 8.9 mb/d of lost flows through the Strait. The IEA’s latest flagship Oil Market Report provided us a clearer picture of how these latter barrels are now being accounted for. Of prominence, roughly 4 mb/d were drawn from global oil inventories in March and April, which stood at a hefty 8.0 billion barrels in late 2025. Much of this is from the U.S. Strategic Petroleum Reserve (SPR). Another roughly 1 mb/d in new supply is coming from higher production from the likes of Canada, Norway, Venezuela and Brazil. Finally, 2.5 mb/d can be accounted for by reduced global demand, mainly in Asia, via demand destruction through higher prices. It’s these four channels that, at least on paper, have done most of the heavy lifting to contain benchmark oil prices, including front-month West Texas Intermediate and Brent futures. Still, we suspect prices are also still being held back by hopes/expectations that the conflict will come to an end and the Strait will reopen relatively soon. This is mainly because the Trump Administration is seen as wanting to bring gasoline prices down ahead of the U.S. midterm elections in November. This view is reflected in the futures market, which shows WTI coming down to And what about the 5 mb/d in missing refined products that used to flow through the Strait? Indeed, it’s these lost barrels of diesel and jet fuel that arguably may be creating bigger problems for the global economy and leading to greater demand destruction via higher prices. They simply can’t be replaced by drawing on previously accumulated inventories. Reserves are in fact much more limited, which could become more problematic as we head into the summer with no resolution to the conflict. Key Takeaway: Benchmark crude oil prices have thus far been contained by some critical supply and demand adjustments. However, there is increasing risk that upward price pressure, particularly for refined products, will build if the conflict drags on. |
