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Fed Uncertainty
The US Federal Reserve had hinted to pause of its year-long rate hiking cycle at the beginning of May, based on the cumulative and lagging effect of its action, as well as the expected contraction in credit conditions from the recent banking turmoil.
This credit tightening however, has not been that significant so far and is mostly a product of the Fed’s rate increases, not the financial stress. Many Fed officials have alluded to that, such as Ms Logan (voter) a couple of weeks back , while Fed of Kansas City said noted that financial stress «may be less effective in reducing inflation» than monetary constraint.
Even though it has been cooling, inflation remains elevated and far from the central bank’s 2% target. Core readings have been particularly sticky for a while now and last week’s PCE report showed an uptick in April. More importantly, headline PCE accelerated 4.4% y/y (from 4.2% previously), in the first increase since June’s multi-decade peak. Furthermore, the labor market remains very tight, with elevated wages and unemployment at five-decade lows.
These indicators call for sustained restrictive monetary stance and markets have been moderating their hopes for an end to the tightening cycle and multiple rate cuts. The hot PCE inflation report accelerated this shift and markets had come to price in another hike in June.
On Wednesday however, we got dovish comments from two Fed voters, who pushed back against such outcome. Mr Jefferson noted that «skipping a rate hike» in the next meeting would allow policymakers to assess more data before deciding on further tightening. He emphasized however that such a hold, «should not be interpreted to mean» that rates have peaked . In the same vein, Mr Harker advocated in favor of skipping an increase, but stressed that this is «not pause». He warned though, that upcoming labor and CPI data «may change my mind».
These remarks point to divisions amongst policymakers, which were also evident in the accounts of the last decision and to increased uncertainty around the next move. The Fed is not alone in this and I had recently argued that central banks are all over the place.
More importantly, this latest commentary sparked another repricing around the Fed’s policy path, this time on the dovish side. CME’s now assigns the highest probability to rates staying unchanged at the June meeting, but still prices in one more hike.
The USDOLLAR dropped after these remarks and the new shift in expectations. Focus now turns to Friday’s Employment Report, which will be critical for the central bank’s next move. Another strong print could make it hard for officials to stay in the sidelines, but weak result could reinforce the case for a hold.
The House of Representatives meanwhile, passed the Fiscal Responsibility Act of 2023, ahead of the June 5 estimated deadline, after which the US government is projected to become unable to pay all of its obligations. The bill needs to also clear the Senate. A successful outcome could enable the Fed to pursue a more aggressive monetary approach.
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