US inflation still high, but Fed is likely to hold
CPI inflation in the US came in broadly in line with expectations in May, with the headline CPI registering a 0.1% m/m gain, and core rising 0.4% m/m. This took annual headline inflation down to 4% y/y, and core inflation down to 5.3%. As expected, the flat headline reading was due to the negative drag from falling gasoline and utility gas prices, which offset continued elevated readings in housing rents, while used car prices continued to rebound.
Core services inflation (excluding medical, transportation and shelter) actually moderated on a decline in the recreation category, which offset continued strength in eating out. We think this cooling in core services is likely a one-off given the persistent strength in unit labour cost growth – something that firms will have to pass on to consumers unless they are prepared to accept lower profit margins. Big picture, inflation is continuing its downtrend – and we expect this to continue over the coming months – but we still see a risk that the supply/demand imbalance in the labour market means that inflation settles at a level materially above the Fed’s 2% target over the medium term.
The lack of an upside surprise will be enough for a Fed pause
While inflation remains red-hot for the time being, the lack of an upside surprise to the June reading allows the Fed to follow through on its recent signalling and to keep monetary policy on hold when the FOMC meeting concludes tomorrow. This would be the first pause in policy for 15 months, during which the Fed raised rates by a breath-taking 500bp. Aside from inflation, the totality of the data since the May FOMC meeting has been mixed. We have had clear signs of strength in the form of a blow-out jobs report for May, when the US economy added around 340k jobs – almost double the trend rate of jobs growth – but we have also had clear signs of weakness. Manufacturing gauges have been particularly weak, while high frequency data for services (daily restaurant reservations and passenger air traffic) and goods consumption (Redbook weekly retail sales) point to stagnation at best. Meanwhile, historically reliable leading indicators such as credit conditions suggest we are on the cusp of a recession. All of this would suggest there is merit in being patient, given how much the Fed has tightened already, and given the lag with which interest rate rises affect the economy.
A pause does not necessarily mean an end to tightening
Still, this decision is likely to be delivered with the caveat that a pause does not mean an end to rate hikes, which leaves a July hike still very much in play. The update to the Fed’s ‘dot plot’ projections will give the Fed the opportunity to signal clearly to markets not to over-interpret a June pause to mean a definitive end to tightening. The Committee could potentially add another 25-50bp to the end-2023 forecast, and/or signal that rates are likely to stay higher for longer by removing some of the rate cuts currently projected to take place in 2024. Our base base continues to be that rates have peaked and that the Fed will start cutting rates from December, but we see the risk tilted towards a higher peak and/or a later start to rate cuts.