As was widely anticipated the Federal Reserve’s Federal Open Markets Committee (FOMC) chose to increase the policy (federal funds rate) target by 25 bps to an upper limit of 5.25 per cent. Moreover, the Fed’s accompanying Statement omitted a line from its previous statement that said the committee “anticipates that some additional policy firming may be appropriate”. That makes it likely that the Federal Reserve (Fed) will “pause” (perhaps indefinitely) any existing disposition to increase the policy rate.
In a press conference following the announcement of the decision, Fed Chair Jerome Powell described the above change as “meaningful” adding that “we’re no longer saying that we anticipate” further increases.
The current plans to “pause” may also be motivated by the enduring difficulties in the regional bank sector. Powell said bank conditions had “broadly improved” since early March but said the strains in the sector “appear to be resulting in even tighter credit conditions for households and businesses”.
However, there remains some difference in view with the bond market when it comes to how far the Fed may reduce the policy rate in 2023.
The Fed has consistently maintained a “higher for longer” characterisation of the likely policy rate path. The bond market on the other hand is pricing some 40 bps of policy rate reductions through to the end of 2023 and a further 100 bps in the first half of 2024.
The bond market has had a tendency over the past couple of years to “cry wolf” regarding recession. Of course, that famous parable concludes with the wolf finally showing up, and the recession wolf will show up at some stage. However, the bond market has not recently proven to be a timely recession sage and nor has it proven to be an any better sage when it comes to predicting Fed action.
My assessment is closer to that of the Fed.
The flipside of seeing a recession wolf lurking in the economic undergrowth is that the bond market has consistently over-estimated the rapidity with which the inflation rate would decline.
And while there have been some slivers of promising news suggesting that inflation pressures are abating, progress remains grudging at best.
And while markets obsess about a potential recession and evidence grows that activity is decelerating, it is a long way from clear that it is doing so in a way that would lead the Fed to contemplate a rapid reversal of policy rate hikes to date.
The Fed’s FOMC median forecasts have GDP growing at only 0.5 per cent this year and the unemployment rate rising to 4.6 per cent. That is not inconsistent with a shallow recession. That means it will take more than a shallow recession for the Fed to meaningfully change course.
What might upset the Fed’s plan is that regional bank woes occasion a severe tightening of credit conditions so that any consequent activity growth correction comes to resemble a more severe and enduring recession.
Perhaps complicating matters, it would not surprise to observe persistent “stickiness” in inflation even if some of the cyclical inflation tailwinds are in some form of abeyance. The reversal of structural currents that account for the deflationary tendency of the past three decades is ongoing: viz; globalisation of labour supply (after the fall of the Berlin Wall and the “export” of labour from large emerging market economies such as China and India) is abating, globalisation of goods markets is in retreat as governments everywhere introduce protectionist measures under the guise of “industrial policy” and “national champions”, while domestic regulation of markets is increasing in scope (leading to upward price pressures) and baby boomer workforce participation is declining (limiting labour supply). The transition to clean energy involves ongoing costs to business, which is not to say it is undesirable, but it does complicate the task for inflation-focussed central banks.
The above makes me view current US bond yields as still a little over-extended on the downside and it would not surprise me to see bond yields grind higher as we approach the northern summer. Of course, with a caveat attaching to enduring difficulties in the regional bank sector.
But the Fed is now “one and done”.
Coming up: ECB to raise the policy rate 25 bps; US April non-farm payrolls
European Central Bank (ECB)
The ECB is likely to raise its policy rate(s) by 25 bps when it meets this evening taking the rates on its deposit facility, main refinancing operations and marginal lending facility to 3.25 per cent; 3.75 per cent; and 4.00 per cent respectively.
While economic activity growth remains tepid, progress on inflation does not yet seem to be of a sufficient magnitude to allow the ECB the benefit of a “pause”. That much was indicated by the release of the “flash” eurozone core consumer price index (CPI) inflation on Tuesday showing the annual rate of core inflation was pretty much as expected at 5.6 per cent. On a headline basis that rate was 7.0 per cent, just slightly above consensus 6.9 per cent. That lack of progress on inflation also reflects a reluctance on the part of the ECB to recognise the seriousness of the inflation challenge that it confronted after an extended period of excessively accommodating monetary policy and supply shocks aggravated by the pandemic and the Russia / Ukraine conflict.
Even if there are some slivers of progress, it is not anywhere near enough to satisfy a purportedly inflation-targeting central bank. Moreover, given ECB President Lagarde’s comments at the last meeting that “inflation is projected to remain too high for too long,” and further that, “if our [inflation] baseline continues after the [financial] uncertainty fades, then we have a lot more ground to cover”, it is difficult not to expect a further hike in the ECB policy rates.
There had been some speculation that the ECB might deliver a 50bp hike. However, the ECB’s Bank Lending Survey released on Tuesday noted that credit conditions had “tightened further substantially” in Q1 associated with both a sharp reduction in loan demand and a tightening in lending standards. That would appear to be sufficient to rule out a more aggressive 50 bp hike.
US April non-farm payrolls
The April US monthly non-farm payrolls report to be released on Friday will of course be keenly watched given the bond markets predilection for expecting policy rate reductions later in the year.
The March report was solid with a respectable increase in employment and the unemployment rate at 3.5 per cent being as low as it has been since 1969. However, wages growth (as measured by average hourly earnings) declined further to 4.2 per cent, consistent with the grudging abatement of inflation pressures evident in the various price-based inflation measures and lower than indicated by other measures such as the Employment Cost Index.
Markets will likely be particularly exercised on the extent to which the March report reveals any further tempering of wage pressure, as well as focussing on conventional measures of employment growth and the unemployment rate.
There have been indications of some meaningful easing in the US labour market.
The March Job Openings and Labor Turnover Survey (JOLTS) report released earlier in the week revealed a second successive sharp drop in US job openings. The number of US job openings fell to its lowest level since April 2021 and was again below market expectations.
The February Institute for Supply Management (ISM) Purchasing Manager Index (PMI) for Manufacturing showed a modest bounce back in employment conditions.
The Services PMI, released overnight, and which is a more telling gauge of the overall strength of the US economy, showed a fall in the employment component but remains in expansionary territory.
The ADP measure of employment, also released overnight, showed a higher than anticipated 296k increase in employment in April.
According to Bloomberg, market expectations for US March non-farm payrolls are for an increase in employment of around 180k (from 236k in March) and an unemployment rate at 3.6 per cent which is still close to a 50-year low. Average hourly earnings are tipped to be unchanged at 4.2 per cent annual growth.
An outcome close to expectations will not move the dial for the Fed. It would take a significantly weaker report to validate the current policy rate path priced by markets. Of greater importance for both markets and the Fed will be next Wednesday’s release of the April Consumer Price Index (CPI). Even a CPI figure that indicates ongoing “stickiness” in prices (say, unchanged year-to-year CPI core inflation) is unlikely to provoke any further Fed policy rate hike.
By Stephen Miller, investment strategist
