FOMC Watch – Patience, not complacency

We expect the Fed to leave the policy rate unchanged at 3.75-4.00% on Wednesday. The decision is more finely balanced than market pricing suggests. Inflation has surprised to the upside for a second month, but declining inflation breadth and a cooling labour market give the Fed room to wait. We therefore expect the Fed to pause in October before delivering a final 25bp hike in December.

Inflation is hot, but the outlook is more benign

September CPI was again stronger than expected. Core prices rose 0.34% m/m, while headline inflation rose 0.65%, raising the annual rate to 3.7%. Unlike August, when the upside surprise was unusually concentrated, September showed broader price pressures. Energy is increasingly feeding through into categories such as airfares, vehicle prices rose, and technology-related inflation remained elevated.

The report is unlikely to have given the Fed confidence that inflation is returning sustainably to 2%. The concern is less the initial energy shock, which monetary policy cannot prevent, than its potential propagation. Persistent input-cost increases raise the risk that firms pass these costs on to consumers and, ultimately, that higher inflation feeds into wages. Restrictive policy provides insurance against those second-round effects. Still, there are reasons not to overreact to two hot prints. Inflation breadth continues to improve, suggesting that the recent acceleration has not yet developed into a generalised inflation process. Moreover, some of the factors currently boosting PCE inflation look set to fade, particularly the unusually large contribution from software and, somewhat later, memory chips. We therefore expect underlying inflation to resume its decline next year, even if near-term readings remain uncomfortable.

Headline CPI may initially suggest otherwise. Base effects are likely to keep inflation elevated into early next year before producing a sharper decline in the spring. The Fed will therefore need to look through near-term volatility and focus on whether price pressures are genuinely broadening.

The labour market gives the Fed time

If inflation keeps the case for further tightening alive, the September labour report explains why that tightening need not come immediately. Payrolls rose by only 29k, alongside 60k of downward revisions to the previous two months. The three-month average has fallen to around 50k. Given slower growth in labour supply, that pace remains solid, but it is neither hot nor indicative of a tight labour market. The rise in unemployment to 4.2% was less concerning because it largely reflected a 0.2pp increase in participation. More important for the inflation outlook, average hourly earnings rose just 0.1% m/m, bringing annual wage growth down to 3.0%. The labour market resurgence suggested by the previous two reports therefore increasingly looks like a mirage.

Combined with the recent softer PCE readings, the labour data remove much of the pressure to hike immediately. The Fed can afford another six weeks to assess whether the latest inflation strength represents persistent pressure or another temporary bump.

Markets have moved sharply towards a hold

The shift towards an October hold reflects Fed communication and tighter financial conditions more than an improvement in the inflation data. Market pricing has moved considerably since the September meeting. The hot CPI report initially drove the probability of an October hike sharply higher, but subsequent Fed communication reversed that move. Markets currently put the probability of an October hike at less than 10%.

Policymakers have persuaded markets that they are willing to move gradually, while higher long-term yields and tighter financial conditions have reduced the urgency of consecutive hikes. Even a December increase is no longer fully priced. That makes Wednesday's communication particularly important, although the minutes may be needed for a clearer picture of the debate.

One more hike

A hold may not be unanimous. One or more participants may favour an immediate 25bp hike because of the recent broadening in price pressures and the risk of second-round effects. For the majority, however, waiting does not contradict the logic of September's hike. That increase was insurance against the energy shock becoming embedded in underlying inflation, not the start of a conventional hiking cycle. The conditions that justified one precautionary increase did not necessarily justify another immediately afterwards.

The mix of persistent near-term inflation risk and a cooling labour market argues for patience rather than complacency. We expect the Fed to hold in October, deliver one final 25bp hike in December, and then keep rates unchanged for an extended period.