Is the Fed’s next move a raise in rates?
Almost nobody thought the fashionable question in the northern hemisphere spring would be whether the Federal Reserve would soon have to raise rates again. But that is where we are.
Definitively hot US inflation data, unlike that in Europe or Japan, has changed the outlook.
Instead of the six to seven quarter-point rate cuts in 2024 that financial markets expected at the turn of the year, they are now expecting roughly one. In options markets, many participants put a probability close to 20 per cent on the next move from the Fed being a rate rise.
At the end of the Fed meeting on Wednesday, Jay Powell is likely to be careful not to rule out a hike. The Fed chair will probably stick to his mantra that the committee has become less confident about the ability to cut rates in the short term.
Others have been less circumspect. Larry Summers, former Treasury secretary, said earlier this month: “You have to take seriously the possibility that the next rate move will be upwards rather than downwards.” He added that recent inflation data indicated the neutral rate of interest was “way above” the 2.6 per cent level believed by the Fed.
To corroborate that, the Fed’s favoured inflation measure has been rising again. Annualised three-month PCE inflation on most measures exceeded annualised six-month inflation however you cut the data. And six-month inflation exceeded 12-month inflation, suggesting there is momentum in US prices and it is not good.
The better news is that there are many reasons to dispute the idea that the Fed will soon be hiking US interest rates from their 5.25 per cent to 5.5 per cent range. Most important is the consideration of both supply and demand trends to assess inflationary pressures.
The first area to look at is the US labour market. There is a lot of labour market data coming out this week after this article goes to print, so caution is required. That said, recent trends still show big improvements in supply of workers from inactivity and immigration hand-in-hand with rapid gains in labour productivity. The combination boosts the ability of the US economy to grow without sparking inflation.
This improvement in labour supply and productivity has allowed labour market indicators to cool from highs in 2022 despite continued rises in employment.
The best way to show this is to get a bunch of labour market indicators and compare their strength with average pre-pandemic levels and their normal variation. This is the “goldilocks” area in the chart below, in which the data sat about around two-thirds of the time between 2001 and the end of 2019.
Whether you look at job openings per unemployed person, the quits rate, the Atlanta Fed’s wage growth measure or the Fed’s preferred Employment Cost Index for private sector wages and salaries, the data is moving back towards the goldilocks zone. In many cases, the chart shows it is already back to pre-pandemic levels.
This range of data suggests that the Fed’s interest rate is restrictive and bringing the labour market into balance, but that it also has a bit further to go before officials can be comfortable. It does not suggest further rate rises are needed.
The second broad set of data showing the economy is reacting to higher interest rates comes from the traditionally interest rate sensitive areas of housing and lending.
The data is not as well behaved as those showing the labour market, but it still indicates that existing home sales, consumer lending and credit card delinquencies (inverted) are coming back into more normal ranges having been hot.
This again suggests the Fed got it right in thinking economic activity and demand is slowing relative to potential supply. You would not expect to see these trends if the monetary policy transmission mechanism was broken.
A third test is simply to look at traditional measures of inflation and note that these are still well down on last year when measured on an annual basis. There is much wrong with the way Europe measures owner-occupied housing in its harmonised index of consumer prices (it ignores it), but on an equivalent measure, core US inflation is already down to 2 per cent. The US is also well on its way to 2 per cent on the core consumer price index (CPI) measure and the personal consumption expenditure deflator (PCE).
Disinflation has not stopped even if it has been disappointing of late.
The fourth argument against rate rises is important although a little circular. Since the start of the year, the movement upwards in expected interest rates has added to the bite exerted by the official overnight rate of 5.25 to 5.5 per cent. Financial conditions have tightened, borrowing rates have risen and this makes the stance of monetary policy tighter than it was at the turn of the year.
Of course it is wrong to take this argument too far, as Lord Mervyn King did almost 20 years ago when the former Bank of England governor postulated a “Maradona” theory of interest rates. He suggested the central bank could allow financial markets to do the work for officials, a prediction that was falsified a little over a year later when the BoE raised rates sharply in 2006 before slashing them in the global financial crisis.
These four reasons still suggest the Fed’s tightening from 2022 is restricting the US economy and helping to bring inflation down.
After three consecutive months of bad US inflation data, however, it is also important to point out what might be wrong with the reasoning above.
The data showing a cooling US economy could start to turn and that would be something to worry about.
A continuation of recent trends in inflation data should also raise concerns. Disinflation needs to reassert itself soon or it will be hard to dismiss the idea that there is excess demand. I’ve put annualised six-month inflation as the default in the graphic below, but if you want to scare yourself, click on the chart and look at the three-month annualised rates.
Finally, there are still many parts of the US economy that do not seem to be sensitive to interest rates and it will be problematic if these continue to run hot.
In the US GDP statistics, despite the cooler 1.6 per cent annualised headline growth rate, quarterly growth rate for real consumer spending of 2.5 per cent was only slightly weaker than at the end of 2023. The savings rate of 3.6 per cent in the first quarter was again low, suggesting few worries among households regarding activity levels.
In the jobs market, cooling in vacancies, quits and wage growth has not been matched with a slowdown in government, health and hospitality jobs growth.
With a Fed meeting and vacancy, wage and jobs data coming this week, I will check back next week to see if signs of the disinflationary process are reasserting themselves. I am ready with the humble pie if not. But for now, the evidence suggests the next move in the Fed’s rates is still downward.
What I’ve been reading and watching
In two columns, Martin Wolf argues the ECB should start cutting rates soon while the Fed should remain on hold “but cannot wait forever”. On the UK, he correctly argues that the BoE should be willing to ask what went wrong in the inflationary episode and what lessons can be learnt. It is remarkable that the BoE (and others) find this question so uninteresting
The Wall Street Journal (£) reports that Donald Trump’s allies are drawing up plans to weaken the Fed’s independence. There is no sign, however, that this has support from the Republican presidential nominee. So far, it’s just people seeking to curry favour with Trump
Interest rate moves in emerging markets are diverging. Indonesia’s central bank raised rates last week and a similar increase in Nigeria has boosted its currency. Central banks in Ukraine, Hungary, Argentina and Costa Rica all cut rates in the past week
The question of UK interest rates will matter for the next UK government. I argued that people are being too negative about prospects for a Labour government. The optimists have a story to tell
A chart that matters
Last week the Bank of Japan held interest rates at the new range between zero and 0.1 per cent, expressing few concerns about the declining value of the yen. “Over to you Ministry of Finance,” the BoJ seemed to be saying. Sure enough, on a public holiday on Monday, the yen arrested its decline amid speculation of heavy intervention from the Japanese authorities. The MoF never confirms or denies intervention immediately.
It also probably does not like others pointing out the decidedly patchy history of Japanese currency intervention. As the chart below shows, it worked in 2011 and eventually in the mid-1990s, but often fails to achieve its ambition.
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