Fed likely to skip, but it's going to be close

Market pricing has shifted massively over recent weeks, but we think the most likely outcome remains the Fed leaving policy rates unchanged on 14 June. There will be some dissent and a shock inflation reading could make it a very close decision. Either way, the Fed will leave the door open to further rate moves.

No change the most likely outcome

Just over a month ago, Federal Reserve Chair Jerome Powell hinted that after 500bp of rate hikes over a 14 month period, interest rates may finally have entered restrictive territory and the Fed could pause at the June meeting to take some time to evaluate the effects. Markets took this as a signal that we may already be at the peak with the fear that the combination of high borrowing costs and tighter lending conditions could prompt a recession with inflation falling swiftly back towards target. On 4 May, Fed funds futures contracts were pricing in 86bp of interest rate cuts by year end and the target range heading below 4% at the January 2024 FOMC meeting.

Over the subsequent six weeks, activity has remained resilient, inflation continues to run hot, payrolls jumped 339,000 and the Australian and Canadian central banks surprisingly hiked rates. Hawkish comments from a few Fed officials have added to the sense that they may not be done. The result is that pricing for the June FOMC meeting is not far off a coin toss (just under 10bp priced) and July is looking a decent bet for a hike (21bp priced). Next Tuesday’s CPI report could see pricing move even further in favour of a hike – currently the consensus is for core CPI to come in at 0.4% month-on-month, but if we get a shock 0.5% that could be sufficient to convince enough FOMC members to vote for a hike.

That’s not our base case and we believe there will be a majority on the committee who think they have tightened policy a lot and it makes sense to wait. This was certainly the commentary from senior Fed officials such as Governor Philip Jefferson and Philadelphia Fed Governor Patrick Harker, that while “there is still significant room for improvement” the Fed is “close to the point where we can hold rates in place and let monetary policy do its work”. Moreover, recent data releases have been sending very mixed messages, which suggests it may make sense pause to evaluate.

Conflicting data makes life hard for the Fed

Friday’s Labour report is a notable example. The establishment survey, which questions employers and generates the non-farm payrolls number, reported a jump of 339,000 in employment in May. However, the household survey, used to calculate the unemployment rate, showed employment declined 310,000 with unemployment rising 440,000. Then we have the manufacturing ISM reporting a rise in its employment survey yet the payrolls report stated there was a 2000 decline. Meanwhile, service sector payrolls rose 257,000 yet the ISM services employment index fell into contraction territory.

We see similar mixed messages within the GDP report. On an expenditure basis, GDP grew 1.3% annualised in 1Q 2023 and 2.6% in 4Q 2022. However, an alternative measure of US economic activity, Gross Domestic Income, which combines all the costs incurred and incomes earned in the production of GDP, contracted 2.3% annualised in 1Q 2023 after a 3.3% drop in 4Q 2022 and has declined in three out of the past four quarters. An average of the two series suggests the economy has flatlined since 3Q 2022.

Fed to leave the door open for further hikes

Nonetheless, the Fed wants to see 0.2% month-on-month or below CPI readings to be confident inflation will return to 2%. We aren’t there yet so if they do hold rates steady, as we predict, it is likely to be a hawkish hold with the door left open to further rate hikes if inflation doesn’t slow – July is clearly a risk. We certainly acknowledge the risk that they hike rates 25bp, especially if Tuesday’s inflation data surprises to the upside, but doubt they will intensify the language on rate hikes so the “hawkish hike” scenario in the table above looks unlikely.