A different kind of Fed pivot?

 Now that the debt ceiling drama is over, investors’ eyes are turning toward the Fed and the trajectory of monetary policy. The current Fed tightening cycle is one of the most aggressive in memory. After a series of staccato rate hikes, the Fed hinted that it was ready to pause. However, the recent stronger-than-expected April PCE may have changed the narrative from a pause to another rate hike.
Will the Fed pause its rate hikes, skip a hike but continue later, or just raise rates at the June FOMC meeting?

Setting expectations

Fed communications have become far more transparent since the days of the Greenspan Fed. The market interpreted May FOMC meeting statement as a hint at a pause in the rate hike cycle:

In determining the extent to which additional policy firming may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.

This was in direct contrast to the “additional firming” language from the March FOMC meeting statement:

The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.

The release of the May FOMC meeting minutes revealed a divided Fed, with a tilt toward a pause. On one hand, “some participants commented that, based on their expectations that progress in returning inflation to 2 percent could continue to be unacceptably slow, additional policy firming would likely be warranted”. On the other hand, “several participants noted that if the economy evolved along the lines of their current outlooks, then further policy firming after this meeting may not be necessary”. “Some” is fewer than “several”, right?

Governor Christopher Waller, who is regarded as a hawk, opened the door to a “skip” in the rate hike cycle in a May 24 speech. He concluded:

I do not expect the data coming in over the next couple of months will make it clear that we have reached the terminal rate. And I do not support stopping rate hikes unless we get clear evidence that inflation is moving down towards our 2 percent objective. But whether we should hike or skip at the June meeting will depend on how the data come in over the next three weeks.

On the other hand, Governor Philip Jefferson, who’s nominated to be Vice Chair and whose views are closer to those of Fed Chair Jerome Powell, said in a separate speech that that hinted at the idea of skipping a rate increase.

A decision to hold our policy rate constant at a coming meeting should not be interpreted to mean that we have reached the peak rate for this cycle. Indeed, skipping a rate hike at a coming meeting would allow the Committee to see more data before making decisions about the extent of additional policy firming.

Arguably, the progress toward lower inflation has been “unacceptably slow”. The April PCE print showed an unwelcome upward surprise in core PCE. In particular, the closely watched super-core PCE, which measures services ex-food and energy and housing, saw the strongest uptick since the start of 2023.

All eyes on the labor market

What will the Fed do? Fed Chair Jerome Powell has acknowledged that goods inflation has been falling, but services inflation remains stubbornly high. He has repeatedly focused on services ex-food, energy and shelter, or “super-core” inflation, as a key metric to watch.

The main component of “super-core” is labor compensation, which means that the Fed will be intensely focused on the jobs market. Two key reports released last week gave updates on the state of the U.S. labor market.
The April Job Openings and Labor Turnover Survey (JOLTS) showed that job openings rose, which is a sign of a resilient labor market. The job openings to hires (blue line) edged up, indicating there were more jobs than applicants, and voluntary quits to layoffs rose (red line). The latter indicator has shown itself to be a noisy but useful leading indicator of the jobs market. While the latest April reading indicated strength, it has been trending downward as a signal of impending labor market weakness.
The May Jobs Report, on the other hand, was a bit of a head scratcher as the report contained good news for both doves and hawks. Headline nonfarm payroll blew past expectations of 180,000–339,000 jobs. The April figure was revised up from 253,000 to 294,000. These figures point to a strong jobs market.
On the other hand, the unemployment rate rose from 3.4% to 3.7%. In addition, MoM average hourly earnings missed expectations at 0.3% and April was revised down from 0.5% to 0.4%, which indicate a weak labor market. As well, average weekly hours fell from 34.4 to 34.3 as a signal of economic weakness.

More crucially, the average hourly earnings of non-supervisory workers, which is less noisy as it excludes the bonuses of managerial workers, showed an unwelcome acceleration.

Notwithstanding the results of the May Jobs Report, the Atlanta Fed’s Wage Growth tracker, which measures median wage growth rather than average hourly earnings, has shown an unwelcome level of stickiness at 6.1%.

As a consequence, Fed Funds futures are now expecting a pause at the June FOMC meeting, followed by a quarter-point rate hike at the July meeting and rate cuts that begin in November.

What’s the Fed’s reaction function?

At the end of the day, making a call on Fed policy is a call on the Fed’s reaction function.

In the short run, the Powell Fed has shown itself to hate surprising markets. Fed Governor and nominated Vice-Chair Philip Jefferson’s speech of a hint at a June pause cemented expectations that rates would stay steady at the June meeting. But incoming data pushed expectations of a quarter-point hike out to July. If the consensus on the FOMC were to shift to a June rate hike, watch for Fed officials to give speeches to guide expectations in that direction.
In the longer run, the Fed tightening cycle has two phases. The first is to raise nominal rates to a level that real rates become positive. That phase has largely been accomplished. The second phase depends on rising real rates. The combination of steady nominal rates and cooling inflation is expected to do most of the heavy lifting to tighten monetary policy. If inflation doesn’t cool, nominal rates will have to rise further.
The JOLTS report hasn’t been helpful as a sign that super-core inflation is cooling. The job openings to hires ratio ticked up, and so did the quits to layoffs ratio. The unexpected acceleration in the hourly earnings of non-supervisory workers also did not help matters. The Atlanta Fed’s wage growth tracker is showing stickiness in wage growth. All these signs point to a labor market that remains extremely tight.
While monthly annualized inflation data can be noisy, May monthly core PCE (blue bars) and the Dallas Fed trimmed mean PCE (red bars) — both tell the story of an unexpected upside inflation surprise. While inflation has generally been trending down, the current episode is reminiscent of the December–January period when core PCE rose for two consecutive months before resuming its decline.
In conclusion, the Fed remains data dependent. Incoming data indicates a further quarter-point rate hike in the near future, either at the June or July FOMC meeting. Further rate hikes may be necessary to contain inflation and the Fed is not afraid to cause a recession in pursuit of its price stability mandate. In fact, the FOMC minutes indicate that Fed staff is forecasting a recession to begin in Q4 2023.

All else being equal, further Fed rate hikes will put a bid under the USD, which tends to be negative for risk assets such as equities. In the short run, a negative divergence has been growing between the greenback and the S&P 500. In all likelihood this will create a headwind for equity prices.

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