Stephen Miller
At its meeting concluding overnight, the US Federal Reserve’s (Fed) Federal Open Markets Committee (FOMC) opted to “pause” in hiking the policy rate hike. However, the Fed indicated that more policy rate hikes may be in the offing as it expressed ongoing anxiety at the pace at which inflation is falling.
In my mind, Tuesday’s May consumer price index (CPI) was consistent with a meaningful turning point in CPI inflation, including service sector inflation. However, the Fed’s Summary of Economic Projections indicated it viewed the inflation outlook as having deteriorated somewhat since the last set of projections were issued back in March.
The Fed now expects inflation, as measured by the core Private Consumption Expenditures (PCE) deflator, to be 3.9 per cent by end-2023 (from 3.6 per cent in March), falling to 2.6 per cent by end-2024 (unchanged from March). The unchanged 2024 inflation projection reflects an assumed higher terminal policy rate, with the median “dot plot” projecting a policy rate of 5.6 per cent by end-2023 (from 5.1 per cent in March), falling to 4.6 per cent by end-2024 (from 4.3 per cent in March).
Reflecting better than anticipated outcomes so far in calendar 2023, gross domestic product (GDP) growth for 2023 was revised upwards to 1.0 per cent from 0.4 per cent in March while the unemployment rate was revised down to 4.1 per cent from 4.5 per cent in March.
But inflation remains the key focus. In his press conference, chairman Powell continued to emphasise the inflation challenge, saying “inflation pressures continue to run high and the process of getting inflation back down to 2 per cent has a long way to go.”
However, the decision to “pause” was a concession to ongoing uncertainties with respect to economic conditions, and a nod to the lags with which monetary policy operates, particularly given the notable tightening in credit conditions evident in the most recent Fed Senior Loan Officer Survey.
The Fed’s retention of its “hawkish” disposition may in some measure be a device to forestall a further easing in financial conditions. The US bond market has consistently over-estimated the rapidity with which the inflation rate would decline and has consistently under-estimated how high the Fed would take the policy rate and how far the Fed is from contemplating any cut in the policy rate. Markets have more recently tempered their difference of view with the Fed, and it may be that the Fed was concerned not to excite too much market exuberance attendant to a policy rate “pause”, hence the attachment of a “hawkish” rider.
I harbour some doubt as to whether the Fed will deliver on its projected rate increases.
Tuesday’s May CPI inflation data suggested meaningful (if somewhat grudging) progress on inflation.
Headline inflation fell to 4.1 per cent from 4.9 per cent in April largely reflecting base effects from falls in energy prices. Core CPI remains elevated at 5.3 per cent from 5.5 per cent in April.
However, measures of the ‘inflation pulse’ are indicative that peak inflation is behind us, and potentially meaningfully so. While the 3-month annualised core CPI was 5.0 per cent in May, which is still above the recent trough of 4.3 per cent in December, other analytical series were more encouraging. The 3-month annualised Cleveland Fed trimmed-mean measure fell to 3.2 per cent in May, the lowest level since March 2021.
The big question regarding future inflation has been over the trajectory of services inflation. Here, there was also some better news. The 3-month annualised rate of services inflation fell to 3.4 per cent, the lowest since September 2021. While the annual rate of services ex-rent of shelter fell to 4.2 per cent, its lowest since December 2021.
It was the “stickiness” in services inflation that had hitherto kept the FOMC on its moderately a hawkish tack. Progress on that front may be grudging, but it is progress nevertheless.
Financial markets reacted to the “pause not a peak” news with relative equanimity.
Given the slivers of good news on inflation, and with US 10-year bond yields getting close to 4 per cent, it is not a stretch to posit that bonds (government and corporate) offer investors a modestly attractive enough yield without the prospect of significant capital losses. In other words, it may be time to “dip a toe in the water” on bond exposure.
A proximate stabilisation in bond yields may be good news for US equity markets, representing as it does the abatement of what has in the past been a significant valuation headwind. However, while equities benefit from stabilising bond yields, the question remains whether earnings estimates have appropriately priced the cyclical downside. Recession remains the big question and the key risk upon which investors continue to focus.
However, even given the “pause not a peak” mantra, the Fed is now close to the completion of the tightening cycle without there yet being evident any extreme dislocation in activity or employment that had been feared at various times by financial markets. Last night’s modest market reaction might be harbinger of a tentative contemplation of more optimistic outcomes that involve the Fed successfully “threading the needle” and engineering a relatively benign disinflation without an excessive dislocation in activity and employment.
That rarely happens, but…?
Coming up: ECB to raise the policy rate 25 bps at tonight’s meeting
The European Central Bank (ECB) is likely to raise its policy rate(s) by 25 basis points (bps) when it meets this evening taking the rates on its deposit facility, main refinancing operations and marginal lending facility to 3.50 per cent; 4.00 per cent; and 4.25 per cent respectively.
While economic activity growth remains tepid, and there were some noticeable downside surprises to headline inflation in the May ‘flash’ CPI, core inflation remains elevated. Ongoing inflation concern will likely be reflected in scheduled updated staff forecasts which are likely to show a small increment in the Eurozone ‘underlying’ harmonised index of consumer prices (HICP) from the 4.6 per cent and 2.5 per cent forecast for 2023 and 2024 back in March. That lingering concern on inflation pressures has led ECB President Christine Lagarde that there is “more work to do”.
That downside surprise comes after a noticeable deceleration in activity measures which followed substantially tighter credit conditions revealed by the Q1 ECB lending survey released earlier in May. That showed both a sharp reduction in loan demand and a tightening in lending standards.
At the moment, financial markets expect a further 25 basis point (bp) increment at the 27 July meeting and in all likelihood that will be the substance of the themes to emerge from Lagarde’s post-meeting press conference.
However, were the trend of sharply declining activity growth and attendant sharp disinflation (beyond that currently expected) to persist and were further evidence of significantly tighter credit conditions to emerge, both markets and the ECB Governing Council might revisit the existing roadmap containing a 25bp increase in July.
By Stephen Miller, investment strategist