Cooler Inflation and Slower Growth should Convert a Fed Skip into a Fed Pause

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Markets in the week ahead will be focused on Wednesday’s FOMC meeting.?We expect the Fed to leave the federal funds rate unchanged although both the post-meeting statement and the dot plot will likely emphasize that inaction this week should be considered “skipping a rate hike” rather than putting an end to monetary tightening.?Indeed, Fed communications could explicitly warn of a possible further rate hike in July.?On balance, however, cooling data on inflation and growth between now and that meeting should be enough to convince the Fed that no further tightening is warranted.?Some of these data will be released this week.

Prospects for Cooler Inflation

On the inflation front, we expect to see very mild increases in PPI inflation on Wednesday and outright declines in import prices on Thursday.?However, markets will be most focused on Tuesday’s May CPI report.

Overall, we estimate that consumer prices rose 0.2% in May and were up 4.2% year-over-year.?This will mark the 11th consecutive decline in the seasonally adjusted year-over-year inflation rate since it peaked at 8.9% last June.?A look at CPI components and what’s driving them suggests that inflation should continue to decline.

We estimate that energy prices fell 9.9% year-over-year in May, as WTI crude oil prices declined from $106 per barrel in May 2022 to $72 last month.?Natural gas prices fell even more sharply from $8.14 in May 2022 to $2.15 a year later.?In both cases, prices may trend up from here – U.S. Energy Department forecasts[1] are looking for a WTI price of $80 and a natural gas price of $3.64 by the fourth quarter of 2024.?

However, even if this turns out to be the case, energy prices experienced by consumers are unlikely to see a significant rise.?Gasoline refiner margins remain very high relative to pre-pandemic levels and, as refining bottlenecks are resolved, gasoline prices could well move sideways despite an uptick in crude oil prices.?Electricity prices could also move sideways in a lagged response to the fall in natural gas prices.?Overall, provided we see slow but steady growth in the U.S. and global economies and avoid any major geopolitical or environmental shock, we don’t expect energy prices to see any significant move up or down for the rest of 2023 and 2024.

We estimate that food prices were still up a painful 6.9% year-over-year in May.?Part of this reflects restaurant and fast-food prices that have been driven higher by rising labor costs.?That being said, most of the food category reflects grocery store prices that had been rising very rapidly due to a spike in food commodity prices following Russia’s invasion of Ukraine, supply-chain disruptions and very strong consumer demand.?

However, food commodity prices have now fallen to levels that prevailed before the Ukraine invasion.?The ISM supplier delivery index, along with other reports, suggests that bottlenecks are no longer a significant issue.?Meanwhile, idiosyncratic issues that boosted egg and milk prices last year seem to have eased.?Perhaps most importantly, lower and middle income consumers are being squeezed by the lagged effect of the end of pandemic aid and this is showing up in lower real spending on groceries.?This should put downward pressure on food inflation for the rest of 2023 and into 2024.???

We estimate that shelter, which has a huge 35% weight within the CPI, rose 8.0% year-over-year in May, accounting for two-thirds of CPI inflation.?The shelter share of CPI can be broken down into roughly 1% for hotels, 8% for actual rent of property, 25% for “owners’ equivalent rent” and 1% for other small pieces.?

Following a post-pandemic surge, hotel rates appear to have stabilized.?More importantly, a seasonally adjusted version of Zillow’s observed rent index shows that asking rents on available units have risen at just a 1.4% annual rate in the six months ending in April.?This stands in very sharp contrast to a 9.3% annualized increase for the same statistic six months earlier and suggests that the government’s measures of rent and owners’ equivalent rent, which lag new rental agreements, should see a significant deceleration in the months to come.

Finally, CPI outside of food, energy and shelter is also likely to decelerate going forward.?The price of both new and used vehicles has stalled in recent months and high auto-loan interest rates, increased supplies and a squeeze on consumer budgets should hold them in check in the months ahead.?Moreover, vehicle prices feed through to both auto insurance and auto repair costs with a lag so these two segments of CPI, which rose by an astonishing 15.5% and 13.3% respectively in the year ended in April 2023, should see much less inflation in the months ahead.?While rising labor costs may impede the decline in inflation in some of these areas, wage growth has actually decelerated over the past year and remains remarkably tame given the tightness of labor markets.

Looking further out, we expect continued mild inflation in June, with another 0.2% month-to-month increase cutting year-over-year CPI growth to just 3.2%.?Thereafter, year-over-year inflation should drift sideways for the rest of the year and then resume its downward trend in 2024, reaching 2.3% by the end of 2024.?This would be roughly in line with the Fed’s 2% target for the personal consumption deflator.?

Prospects for Slower Growth

While prospects for lower inflation look good, the outlook for real economic growth remains very uncertain.?Real GDP rose at a 1.3% annualized rate in the first quarter and our models predict a similar outcome for the second.?Both retail sales and manufacturing output appear to be relatively weak, as should be confirmed by reports due out on Thursday.?However, payroll employment growth in May was very strong, job openings remain well above normal, the downturn in homebuilding appears to have abated and corporate profit growth in the first quarter handily beat expectations.?

All of this being said, we have seen an increase in layoff announcements and unemployment claims in recent months along with some increase in loan delinquency rates.?The resumption of student loan payments later this summer should put further pressure on consumers.?Most importantly, while bank deposits have stabilized in recent months, following regional banking turmoil earlier this year, at best, the economy will be constrained by tighter bank credit for the rest of the year and into 2024.?At worst, a renewal of financial volatility could tip a slow-growing U.S. economy into recession.

A Skip Turning into a Hold

The FOMC should weigh progress on inflation against the risk of recession in its meeting this week.?Looking at these two issues separately, it would seem to be an easy call – there is no need to raise the risk of recession any further to combat an inflation problem that is so clearly fading.

It should be an easy call – but that is not likely to be the message from the Fed this week.?Indeed, it is possible that the post-meeting statement and press conference could reveal some dissent on the committee, with some voting to hike further at this time and others indicating a bias towards tightening again in July.

On balance, however, we think the numbers just won’t support any further tightening and this will become clearer in the next few weeks.?If so, the investment environment could support lower long-term interest rates, a lower dollar and further gains in stock prices, as investors no longer have to fight a Fed that no longer has to fight inflation.??

[1] See Short-Term Energy Outlook, June 2023, Energy Information Administration

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