Is the Fed’s next move a rate hike?

Almost no one thought that the hot question this spring in the Northern Hemisphere would be whether the Federal Reserve would soon raise rates again. But that’s where we are.

The US inflation data, definitely hot, unlike those from Europe or Japan, has changed the outlook.

Instead of the six- to seven-quarter-point rate cuts in 2024 that financial markets were expecting at the start of the year, they are now expecting about one. In options markets, many participants estimate a near 20 percent chance that the Fed’s next move will be a rate hike.

At the end of the Fed meeting on Wednesday, Jay Powell will probably refrain from ruling out an increase. The Fed chair will likely stick to his mantra that the committee has become less confident about the ability to cut rates in the near term.

Others were less circumspect. Larry Summers, former Treasury Secretary, said earlier this month: “We must take seriously the possibility that the next rate movement will be upward rather than downward.” He added that recent inflation data indicated that the neutral interest rate was “well above” the 2.6 percent level estimated by the Fed.

To support this, the Fed’s preferred measure of inflation has risen again. Three-month annualized PCE inflation on most measures exceeded six-month annualized inflation, no matter how you scaled the data. And six-month inflation has exceeded 12-month inflation, which suggests that there is price momentum in the United States and it’s not good.

The best news is that there are plenty of reasons to dispute the idea that the Fed will soon raise U.S. interest rates from 5.25 percent to 5.5 percent. The most important thing is to consider supply and demand trends to assess inflationary pressures.

The first area to look at is the US job market. A lot of labor market data will be released this week after this article is published, so caution is advised. That said, recent trends still show strong improvements in the supply of workers from inactivity and immigration, alongside rapid gains in labor productivity. This combination strengthens the ability of the U.S. economy to grow without triggering inflation.

This improvement in labor supply and productivity has allowed labor market indicators to weaken from 2022 peaks, despite continued employment growth.

The best way to demonstrate this is to obtain a set of labor market indicators and compare their strength with pre-pandemic average levels and their normal variation. This is the “Goldilocks” zone in the chart below, which the data was in about two-thirds of the time between 2001 and the end of 2019.

Whether it’s job openings per unemployed person, the quit rate, the Atlanta Fed’s measure of wage growth, or the Fed’s preferred employment cost index for private sector wages and salaries, the data returns to the Goldilocks zone. In many cases, the chart shows that the situation has already returned to pre-pandemic levels.

This data set suggests that the Fed’s interest rate is restrictive and balancing the labor market, but that it still has a little way to go before policymakers are comfortable. This does not suggest that further rate hikes are necessary.

The second major body of data showing the economy is responding to rising interest rates comes from the traditionally interest rate-sensitive areas of housing and lending.

The data isn’t as good as the labor market, but it still indicates that existing home sales, consumer loans and credit card delinquencies (reversed) are returning to more normal ranges after being hot .

This once again suggests that the Fed was correct in thinking that economic activity and demand are slowing relative to potential supply. These trends would not be expected if the monetary policy transmission mechanism were broken.

A third test is to simply look at traditional measures of inflation and see that they are still much lower than last year when measured on an annual basis. There are a lot of problems with the way Europe measures owner-occupied housing in its harmonized consumer price index (it ignores this), but on an equivalent measure, underlying inflation in the States -United States has already fallen to 2 percent. The United States is also on track to reach 2 percent for the core consumer price index (CPI) and the personal consumption expenditures (PCE) deflator.

Disinflation has not stopped although it has been disappointing recently.

The fourth argument against raising rates is important if a bit circular. Since the start of the year, the upward movement in expected interest rates has added to the impact exerted by the official overnight rate, from 5.25 to 5.5 percent. Financial conditions have tightened, borrowing rates have increased, making monetary policy more restrictive than it was at the start of the year.

Of course, it is wrong to take this argument too far, as Lord Mervyn King did almost 20 years ago when the former Governor of the Bank of England postulated a “Maradona” theory of interest rates. interest. He suggested that the central bank might let financial markets do the work for authorities, a prediction that was falsified just over a year later when the BoE raised rates sharply in 2006 before cutting them. during the global financial crisis.

These four reasons still suggest that Fed tightening starting in 2022 is constraining the U.S. economy and helping to lower inflation.

However, after three straight months of poor US inflation numbers, it is also important to point out what could be wrong with the above reasoning.

Data showing a slowdown in the US economy could begin to reverse and that would be a cause for concern.

The continuation of recent trends in inflation data should also raise concerns. Disinflation must reassert itself soon, otherwise it will be difficult to dismiss the idea of ​​excess demand. I’ve put six-month annualized inflation as the default in the chart below, but if you want to scare yourself, click on the chart and look at the three-month annualized rates.

Finally, many parts of the American economy still do not seem sensitive to interest rates and it would be problematic if they continued to heat up.

In U.S. GDP statistics, despite a weaker overall annualized growth rate of 1.6 percent, the quarterly growth rate in real consumer spending of 2.5 percent was only slightly weaker than at end of 2023. The savings rate of 3.6 percent in the first quarter was again low, suggesting little concern among households about activity levels.

In the labor market, the slowdown in vacancies, resignations and wage growth has not been accompanied by a slowdown in job growth in the civil service, health and civil service sectors. hotel.

With a Fed meeting and data on vacancies, wages and employment coming this week, I’ll check back next week to see if signs of the disinflationary process are reasserting themselves. I’m ready with the humble pie otherwise. But for now, evidence suggests the Fed’s next rate move remains on the downside.

What I read and watched

• In two columns, Martin Wolf argues that the ECB should soon start cutting rates while the Fed should stay on the sidelines “but can’t wait forever.” On the UK, he rightly argues that the BoE should be prepared to ask what went wrong during the inflationary episode and what lessons can be learned from it. It is remarkable that the BoE (and others) find this issue so uninteresting

• The Wall Street Journal (£) reports that Donald Trump’s allies are developing plans to weaken the independence of the Fed. However, there is no indication that this proposal enjoys the support of the Republican presidential candidate. So far, it’s just people trying to curry favor with Trump.

• Interest rate developments in emerging markets diverge. Indonesia’s central bank raised rates last week and a similar hike in Nigeria boosted its currency. The central banks of Ukraine, Hungary, Argentina and Costa Rica all cut rates last week.

• The issue of UK interest rates will be important for the next UK government. I have argued that people are too negative about the prospects of a Labor government. Optimists have a story to tell

A graph that counts

Last week, the Bank of Japan kept interest rates in a new range of between zero and 0.1 percent, expressing little concern about the fall in the value of the yen. “The Ministry of Finance is yours,” the BoJ seemed to say. Indeed, on Monday, a public holiday, the yen stopped its decline amid speculation about a massive intervention by the Japanese authorities. The Ministry of Finance never immediately confirms or denies intervention.

He probably also doesn’t like it when others point out the decidedly uneven history of Japanese monetary intervention. As the chart below shows, it worked through 2011 and eventually into the mid-1990s, but often failed to achieve its ambitions.