just now
March 21, 2023 - Developments over the past couple of weeks have made this month's interest rate decision from the FOMC a much closer call than considered previously. From Fed-Chair Powell suggesting in his semi-annual monetary report at the start of March that a 50bps hike remained on the table, the subsequent softer employment numbers seen on 10th March and the collapse of Silicon Valley Bank that same day has seen the market scale back its expectations of what the FOMC will deliver. With uncertainty continuing to infect the financial markets, even at this late stage FOMC members may well have not yet decided which way to vote tomorrow. But what can probably be taken as read is that deliberations will no longer be considering the merits of a 50bps hike, but rather whether to hike by 25bps or not at all.
The ‘hawks’ on the FOMC will almost certainly argue that CPI remains too high and that further monetary tightening is needed. But the counter argument is that the current banking crisis requires a more sympathetic approach - it is surely more important to ensure the stability of your financial system rather than demonstrate your determination to fight inflation, particularly given that achieving the latter requires the former. And given the tightening delivered to date, nobody should be questioning the FOMC’s inflation-fighting resolve: no one is likely to criticise the FOMC if it decides to keep rates on hold.
However, given how it got the ‘transitory’ inflation argument so wrong, the temptation to tighten policy further will probably be too strong to ignore and our base scenario is that a 25bps hike will be delivered. But the arguments in favour of pausing are growing and there are valid economic reasons for suggesting that the Fed needs to begin softening its hawkish stance if the risk of a US recession is to be avoided.
Economic Indicators can provide the FOMC with the excuse to pause this month
Much of the discussion at this month's FOMC meeting will revolve around the Fed’s monetary response to the current banking crisis. However, beyond the stresses being seen in the financial markets, emerging data is increasingly pointing to the risk of an economic downturn, suggesting that the Fed is at risk of engineering a recession if the current hawkish stance is maintained. There are compelling economic reasons for keeping interest rates on hold:
- Despite the stronger than expected rise in the non-farm payrolls number for February, the report showed a 0.2% jump in the unemployment rate and a modest 0.2% rise in hourly earnings. This small increase in earnings translates to a 3mth/3mth annualised rate of 4.3%, the lowest print since summer 2021. Moreover, the (admittedly more volatile) 3-mth annualised rate is now running at just 3.6%, putting wages growth roughly back on a level consistent with the Fed’s inflation target. Beyond the wages angle, survey data from both regional Fed surveys and the National Federation of Independent Business are showing hiring intentions slowing down. The re-hiring explosion seen post-covid is coming to an end and it will only be a matter of time before this downturn starts to be seen in the BLS labour survey.
- The February PPI reading fell 0.1%, while January’s readings – both headline and core – were revised downwards by 0.4%. The impact of this has been to leave the y/y core rate now running at 4.6%, sharply down from the 6.0% reading seen in January. The key changes made to the January numbers were in the trade services component - i.e. margins – with the measure for wholesale and retail margins cut by -1.1%. Margins account for nearly one quarter of core PPI and their rapid increase seen during the Covid pandemic, as supply chain disruptions exploded, passed straight into both core CPI and PCE. However, as supply chains ease, so margins are now falling and the margin drops of 0.9% and 0.8% seen in January and February (excluding fuel) have left the quarterly annual rate at -1.4%, bringing the annual rate of increase down to 3.6%, a sharp drop from the 18.1% peak figure seen in March 2022. This fall is bearing down heavily on PPI. Core PPI is a close analogue of the PCE deflator number - the key inflation measure targeted by the Fed - and it is reasonable to expect the end-March PCE reading to show a decline similar to that reported in the PPI number. The FOMC’s medicine is starting to take effect.
- US manufacturing output is under pressure. Despite the small 0.1% rise seen in February, the underlying picture is weak, February’s reading sharply down from the 1.3% print recorded in January. Manufacturing hours worked fell by 0.5% while the key auto and machinery components fell by similar amounts. In addition to this, regional survey data are continuing to show falls in both manufacturing activity and capital investment. Although this survey data is extremely volatile, the collective signal in aggregate is unambiguously downbeat and pointing to further declines ahead, with the falls in capital investment potentially signalling a forthcoming US recession.
- The March University of Michigan (UoM) 5yr/10yr inflation expectations reading – closely watched by the Fed for any emerging signs of potential upwards pressure on wages – fell from 2.9% to 2.8%, ensuring the index has remained in the narrow 2.7%-3.1% band seen since mid-2021. The 12-mth expectations figure fell from 4.1% to 3.8%, its lowest reading since April 2021. Although the Fed would prefer to see both readings lower, the clear message is that inflation expectations are not racing away. Moreover, the declines seen in global food and energy prices are yet to feed through fully into domestic inflationary measures, pointing to further downwards pressure on the 12-mth reading going forward. If the Fed still has fears over a potential wages/price spiral, then the UoM numbers should be helping to assuage them.
But the CPI numbers continue to make for uncomfortable reading
However, the latest CPI figures still do not present comfortable reading for the Fed. In particular, core service prices ex-housing – the current obsession of the Fed – rose by 0.51% on the month, its biggest increase since last September, and the Fed will likely be concerned that annual core services inflation as a whole is falling too slowly, dipping only 0.1% in February and still only 1.1% lower than the peak seen last September. This will not be sufficient to dissuade the ‘hawks’ on the FOMC of the need for another rise in interest rates.
And pausing the hiking cycle carries risks of its own
While the are valid arguments for pausing, such a policy does not come without risks. If the liquidity interventions being undertaken by central banks to calm financial markets are successful, there is a risk that financial conditions may return to insufficiently restrictive levels, jeopardising some of the progress that has been made to date in squeezing demand out of the economy. Further, for the Fed to suddenly abandon its policy of monetary policy being data dependent, ie failing to tighten further despite CPI continuing to run hot, risks damaging its inflation-fighting credibility. And perhaps most importantly, there is always the danger that a failure to hike tomorrow risks sending out the message that “the Fed knows something we don’t”, generating further panic and turmoil in the financial markets.
Overall a 25bps hike is expected
On balance, there seems to be no real rush for the Fed to hike. Both the economic data and the need to restore confidence in the banking sector suggests keeping policy on hold would be the most prudent course of action. Moreover, keeping rates on hold until May is not going to make any material difference to how fast CPI returns to target, while the Fed maintains the capability to implement intra-meeting hikes should the April employment and inflation numbers prove uncomfortably strong. Delaying also gives the Fed time to assess developments in the financial markets, most notably the risk that the banking sector adopts more restrictive lending practices, potentially obviating the need for further official tightening.
But the expectation is that we will get a further 25bps increase, likely accompanied by an increase in the terminal rate forecast by 25-50bps. To go from raising expectations of a 50bps hike just a couple of weeks ago to doing nothing now is probably too much of a volte-face for the FOMC, especially so given that the ECB itself raised rates by 50bps this month.
Indeed, in some respects the ECB has already provided the blueprint for the FOMC's meeting, communicating to the market that a further tightening in policy was necessary to keep downwards pressure on inflation but emphasising that the pursuit of financial stability remained equally as important. Powell is likely to frame the latest FOMC decision in similar language.
