Cooling labour market to drive Fed pause; BoE to hike once more

FOMC Preview: Cooling labour market paves way for end to rate hikes

We expect the Fed to keep rates on hold this coming Wednesday, and financial markets are pricing a near-zero probability of a hike. While the US economy continues to grow robustly, and inflation remains well above the Fed’s 2% target, the labour market has seen a clear and significant softening in recent months, which is dampening wage growth and therefore reducing upside risks to the medium term inflation outlook. Payrolls growth has slowed significantly: the 3 month average monthly jobs gain has fallen from around 330k at the beginning of 2023, to less than half that pace at 150k as of the last August reading. Over the same time period, job vacancies have fallen by nearly 2 million, and the ratio of job vacancies to unemployed people has fallen to 1.5 – still on the high side, but now not far above the pre-pandemic level of 1.2. This broad easing in labour market tightness has helped dampen wage growth, with various wage growth measures now cooling rapidly (see below, and also here). Given that wage growth is the main driver of the medium term inflation outlook, this cooling in the labour market is likely to give the Committee the confidence to keep rates on hold at this meeting, even as headline inflation rebounds.

The September FOMC meeting also brings the quarterly update to the Committee’s projections. This is likely to show upgrades to GDP growth and headline PCE inflation (due to higher oil prices), but core PCE inflation projections are likely to be broadly unchanged. We also expect minimal changes to the Committee’s outlook for interest rates, or the ‘dot plot’; in June, the median Committee member expected one further hike (after July) this year, and 100bp of cuts next year. It is possible that rate cut expectations are reduced somewhat, but we do not expect any changes here to be market-moving. This leaves the focus for markets on Chair Powell’s press conference performance. We expect Powell to express optimism over the continued cooling in the labour market and the accompanying disinflation, which has come alongside continued strength in economic growth. At the same time, we expect Powell to reiterate that the Committee remains open to further rate rises should that prove necessary. He may also point to the recent rise in oil prices as a risk to the inflation outlook, should this push inflation expectations higher (not our base case). We continue to think the Fed is done raising interest rates, and that a further softening in the labour market combined with declining core inflation will trigger rate cuts starting from March next year.

BoE Preview: Lingering wage pressures to trigger one last hike

We and consensus expect the Bank of England to raise its policy rate by 25bp this coming Thursday, taking Bank Rate to a new post-financial crisis high of 5.5%. Although unemployment has started rising in the UK, and labour market tightness has eased significantly, wage growth is yet to peak and – at 7.8% y/y as of July – is far above levels that are consistent with the Bank meeting its 2% inflation target anytime soon. Given this, and despite some recent dovish remarks from Governor Bailey, we expect the MPC to press ahead with a hike. With no update to the Bank’s projections at this meeting and no press conference, the market focus will be on the accompanying policy statement and minutes for clues on the future path of rates. We expect the MPC to maintain its openness to a further rise in interest rates, but given the significant volatility in UK macro data over the past year, and the mixed signals the economy has been sending, we think the Bank will continue to avoid giving clear forward guidance and instead only keep its tightening bias.

Our base case is that this will be the last rate hike of the cycle. Despite the very elevated wage growth readings, we think this is lagging the broader softening in the labour market, and that it reflects an attempt by workers to make up for prior losses to real incomes following the energy crisis rather than being a result of labour market tightness. With unemployment rising and the energy crisis having receded, our base case is that wage growth will peak very soon. This should convince the MPC to be patient at coming meetings, and to wait for the impact of previous rate hikes to fully materialise. Still, we expect rate cuts next year to proceed at a much slower pace than for the Fed, as we expect core inflation to remain more sticky for longer in the UK than in the US. This is due to historically higher inflation expectations in the UK, which is likely to mean that wage growth takes longer to fall back to levels consistent with 2% inflation, even assuming the unemployment rate in the UK continues to rise.