US Economy A close decision for the Fed

The ISM Manufacturing PMI rebounded modestly to 47.1 from 46.3 in March, while a jump in auto production helped to lift manufacturing output by 1%. The Services PMI improved to 51.9 from 51.2, a level consistent with subtrend growth. Nonfarm payrolls gained 253,000, while the unemployment rate ticked down to 3.4%, matching the multi-decade low hit in January. Headline CPI inflation slowed to 4.9%, down from a peak of 9.1% in June, but service prices continue to rise rapidly. Retail sales rose by 0.4% after declines in February and March. The Federal Reserve raised rates by 25 basis points on 3 May, setting the federal funds target range at 5–5.25%. Negotiations over the debt ceiling appear to be making some progress ahead of an early June X-date.

Balancing the risks

In recent days, several FOMC members have made public comments regarding the policy outlook and in particular their thinking about the upcoming meeting on 13–14 June. Some members are clearly leaning toward another rate hike and others are leaning more toward a pause, but for the most part they remain uncommitted. In our view, the decision on whether to raise rates is so finely balanced that it could still go either way depending on how events unfold between now and the meeting. Payrolls on 2 June and CPI on 13 June will be key data releases. At one point, markets had almost completely priced out another hike, but currently the market sees around a 50% chance of one more hike, either at the June meeting or at the following meeting on 25–26 July.

Good arguments can be made on both sides of the debate. Those arguing for hiking will note that inflation is still far above the Fed's 2% target and that the unemployment rate is at a historically low 3.4%. Wage growth has moderated somewhat but is still too high to be compatible with 2%inflation over the medium term. The latest University of Michigan Survey of Consumers showed long-run inflation expectations at the top of its range over the past 20 years, and the longer that inflation stays high, the more likely it becomes that expectations will rise to troubling levels for the Fed. Under normal circumstances, this data would clearly support another hike or even more than one hike.

However, those arguing for a pause will note that circumstances are not normal, and that the Fed must also consider the downside risks to hiking further.

First, the Fed has already raised rates by 500 basis points, while also conducting quantitative tightening. That is a lot for the economy to absorb, and there is a lot of uncertainty over the lagged impact of those hikes.

Second, banks were tightening their lending standards even before the recent banking system stress, which has negative implications for the growth outlook. Consensus forecasts call for GDP growth to turn negative in 2H23, and the FOMC's own forecasts from the March Summary of Economic Projections were also pessimistic, calling for an unemployment rate of 4.5% at the end of the year.

Third, inflation has been trending lower since peaking last June and appears highly likely to slow further in the months ahead.

Fourth, there is risk around the debt ceiling debate. While we believe that there are good chances for a resolution before the FOMC meeting, any deal would almost certainly include some fiscal tightening, which should reduce the need for the Fed to hike rates. Going past the debt ceiling deadline would have serious consequences, and in that event there is almost no chance that the Fed would hike.

Main contributor - Brian Rose

Content is a product of the Chief Investment Office (CIO).

Original report - A close decision for the Fed, 23 May 2023.