Will the Fed pause in June?

With the US debt ceiling issue now in the rear-view mirror, market focus has shifted squarely to the upcoming Federal Open Market Committee meeting on 14 June, and whether the Fed will pause or raise interest rates by another 25bp. At the May meeting, Fed Chair Powell indicated that the central bank had likely done enough to warrant a pause in June, to allow more time to assess incoming data, after an unprecedented 500bp in rate hikes in a little over a year and uncertainty over the impact of tighter lending standards mid-sized banks.

Despite a consensus at the start of the year that the US would enter a recession in 2023, the economic data has proved remarkably resilient as we approach the half-way point, complicating the Fed’s decision making.

On Friday, the May employment data once again confounded expectations with a blowout 339,000 new jobs added, and upward revisions to the March and April figures as well. The US labour market appears to be showing little sign of softening, barring the increase in the unemployment rate from 3.4% to 3.7% last month. Job openings increased again in April and initial jobless claims also tracked lower in May.

At first glance, these strong labour market indicators are at odds with widespread reports of redundancies at tech firms that have hit the headlines in the last few months. However the detailed non-farm payrolls data show that the number of jobs in the information sector, which would cover most of the tech jobs, fell by 9000 in May. Another 2000 jobs were lost in manufacturing, which is also consistent with recent survey data showing weakness in the manufacturing sector. This has been more than offset by strength in the services sector, which is also reflected with the May payrolls data - the bulk of new jobs last month was in services, particularly health care and social assistance, professional and business services, and transportation and warehousing.

The tight labour market has undoubtedly been a key factor in supporting overall household consumption spending in the US, even in the face of higher borrowing costs and elevated inflation.  Inflation-adjusted personal spending growth is still above 2% y/y and, notwithstanding the rise in credit card debt, consumer balance sheets are still healthy. San Francisco Fed researchers estimate there is still around USD 500bn of excess savings by US households, which could continue to support consumer spending through end the of this year.

Against this backdrop, it is perhaps unsurprising that inflation has proved stickier than expected. While headline CPI has indeed slowed to 4.9% in April from 6.4% at the start of the year and peak of over 9% in June 2022, this has largely been due to slower food (and other goods) inflation and lower energy prices compared with a year ago.

However, core inflation, which excludes volatile food and energy prices remains relatively high at 5.5%, almost unchanged since January. Housing costs in particular have continued to rise at a sustained pace so far this year, and transport services inflation remains in double-digits.

While the Fed’s preferred inflation benchmark (the core PCE deflator) is slightly lower at 4.7%, this too has barely budged since January and remains well above the 2% target.

There is then a case to be made for the Fed to raise rates again at the June meeting, and the market is now pricing a 30% probability of a 25bp hike this month. However, the weakness in the household survey, which indicated 310,000 jobs lost last month and a rise in the unemployment rate to 3.7%, will likely give the central bank enough reason to pause, particularly if the May inflation data shows a further moderation in both headline and core inflation, as is expected. 

Read this column in The National