FOMC Preview – Increased confidence on inflation, patience running out
The FOMC will keep its key policy rates on hold this week, but will start paving the way for a September rate cut. In recent months the balance of risk between price stability and full employment has shifted towards a more even stance. While inflation is generally coming down in line with expectations, and growth continues to surprise to the upside, signs of a weakening labor market are becoming increasingly clear, leading to an increasing amount of calls for a rate cut as early as this July meeting.
The hard data shows that the unemployment rate rose for the third consecutive month to 4.1% in June, and jobless claims have continued to increase over July. Non-farm payrolls are steadily weakening, and we expect a further downward revision of this data. The openings-to-unemployed ratio is back to pre-pandemic levels. Unemployment has a tendency to rise rapidly after a tipping point is reached, but we do not think we are near that point as we are still seeing relatively broad-based job creation. We rather expect a moderate further rise in the unemployment rate before imminent rate cuts start to release the brake on the economy.
Meanwhile, last week’s inflation and growth releases continue to support a soft-landing narrative. While the PCE inflation release perhaps disappointed a bit relative to the CPI reading, recent releases have very clearly been at odds with the higher readings in the first quarter of the year. Fed officials are gaining confidence that inflation is coming down to target, especially considering the fact that June saw the lowest m/m reading of shelter inflation in over three years. GDP growth in Q2 came in surprisingly strong at 2.8% annualised versus 2.0% consensus, following a weaker quarter in Q1 (1.4%). While part of the surprise could be explained by a build-up of inventories, overall underlying demand, as measured by private domestic final purchases, came in equally strong at 2.6% annualized. We do expect growth to slow down in the second half of the year, as the labor market and consumer spending continue to cool.
A little bit more patience for a rate cut is needed. At the time of writing, markets are pricing in a negligible probability of a cut this July meeting, but more than pricing in a single cut in September. We do not expect any explicit guidance for September, as the Fed will have another opportunity to do so at the Jackson Hole symposium at the end of August. By then, another set of inflation and labor data points will be available, which we expect to come in consistent with a September cut. Rather, we expect this week’s FOMC statement to reflect the shift in tone of communication we’ve observed over the past month. In particular, we expect it to highlight the two-sided nature of risks, with risks to inflation coming down, while risks to the labor market are increasing.