What to expect from the Fed?

The Federal Reserve faces an unusually close decision at this week’s FOMC meeting. There is a wide range of views on the committee, and Chair Jerome Powell may have difficulty achieving a consensus that everyone can support.

Given the recent economic data, it would not be difficult for the Fed to justify a rate hike. Inflation continues to run well above its 2% target. CPI data for May showed headline inflation slowing to 4% year-over-year, down from a peak of 9.1% last June. However, core CPI has risen by 0.4% month-over-month for the last six months, a reminder that the underlying inflation trend is still too strong. Demand for goods, especially autos, has been rising so far this year, keeping prices higher than we expected. Meanwhile, service prices continue to march higher, as strong demand meets tight capacity on the supply side.

Another problem for the Fed is that the labor market still looks very tight. Nonfarm payrolls rose by a stronger-than-expected 339,000 in May, and, combined with upward revisions to the prior two months, this lifted the three-month average to 283,000, up from 222,000 previously. The latest reading on job openings also showed a surprise increase back above 10 million, and the Atlanta Fed’s wage tracker showed an increase of 6% year-over-year in May, far too strong to be compatible with a sustained 2% inflation.

In fact, the main reason for thinking that the Fed won’t hike this time is the public statements from the Fed’s leadership, including Powell. Advocates for skipping a hike argue that the Fed has already raised rates by 500 basis points, and that monetary policy works with a lag. While the Fed may need to hike a little more in order to bring inflation down in a reasonable amount of time, policy is already restrictive, and the Fed is at least close to the end of the hiking cycle. Consensus economic forecasts call for negative growth in the second half of 2023, which starts in three weeks, and Fed staff are also projecting a mild recession. With banks tightening their lending standards further, there are obvious downside risks to growth. It therefore might be prudent to wait and see how the situation develops before hiking further.

Our expectation is that the Fed will leave rates unchanged, in line with market pricing. However, we also expect policymakers to send a clear message to markets that at least one more rate hike is likely at a later meeting. Raising the “dots” for both 2023 and 2024 would signal an intention to leave rates higher for longer, while also giving the doves on the committee another few weeks to prove that inflationary pressures are waning.

What will we be watching?

Regardless of the Fed’s decision, it will be important to carefully examine the messaging that goes along with it. The FOMC statement and Powell’s news conference offer an opportunity to communicate their intentions to markets. The main message should be that the Fed remains committed to bringing inflation down, that the Fed will raise rates further if necessary to achieve that goal, and that it does not intend to start cutting rates anytime soon. Powell is likely to repeat that the Fed is data-dependent, and that it will make future policy decisions on a meeting-by-meeting basis.

Over the next few days, there are also some key economic data releases that could influence the Fed’s thinking. These include producer prices, import and export prices, retail sales, industrial production, and the University of Michigan’s survey of consumer sentiment.

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Co-authored with Brian Rose, Senior US Economist