Don’t underestimate the resolve of central bankers

In the UK, inflation remains stubbornly high and interest rates will clearly remain elevated for some time. However, inflation in the US has fallen substantially from the peak in June last year and the prospect of the annual rate hovering around 3 – 3.5% for the rest of the year remains high. Is this enough for The Federal Reserve to say, “job done!” Is the interest-rate cycle about to turn?

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In the US, a combination of higher interest rates, easing supply chain constraints (including the rebalancing of the impact from Ukraine war) and tighter credit conditions has helped tame inflation this year. As of June, the annualised rate of consumer price index (CPI) inflation has declined for 12 months in a row. This should allow the Federal Reserve (Fed) to start easing off, shouldn’t it? Core inflation, which excludes volatile food and energy prices, has remained elevated and in May it was at 5.3% year-on-year. This is because energy prices have moved from being a key contributor to overall inflation in 2022 to being a major detractor in 2023 so far. Excluding this component from the core measure highlights that the other price components are not falling as fast – and there is still work to do to get control of inflation in parts of the system.

The optimistic will be disappointed

For quite some time there has been a significant number of market participants having a rosy view of Fed's future actions. Since the latter part of 2022, expectations of a near-term ‘pivot’ have been significant on the basis that the US economy was heading into recession and the Fed’s job would be done. When a central bank transitions from tightening policy to loosening or vice-versa, the Fed is said to be pivoting and it is a significant time for markets.

After raising rates for ten consecutive meetings, the Fed bucked the trend at its June meeting and left interest rates unchanged. Signals from Fed members meant this was already expected. However, the bullishness of the accompanying statement alongside the Fed’s decision to pause its series of increases was surprising.

A ‘dot plot’ of interest rate projections from each member of the rate-setting Federal Open Markets Committee indicated that the median expectation was for two more quarter-point increases in the federal funds rate this year – with no interest rate cuts in 2023 at all.

The minutes from the meeting showed officials intend to resume raising interest rates in July after the June pause and were consistent with the Fed’s statement in June after the meeting. Almost all officials who participated in the June meeting said that additional increases in interest rates would be appropriate, citing risks including the “tight” labour market. The minutes noted that policymakers agree it’s “quite likely” the US will enter a recession this year, although stated that such a downturn stemming from the rate hikes will be “neither deep nor prolonged.”

The Fed has two jobs: keep prices stable and maximise employment.

The central bank’s aggressive pace of interest rate rises to try and return to price stability has not had a significant impact on employment – not yet anyway. Although the Fed can be said to be fulfilling its brief on employment, strength in the US jobs market is problematic. A strong jobs market is more likely to push wages higher, which could contribute to higher inflation in the future.

A wage-price spiral is a considerable economic danger. If workers see inflation eroding their spending power – making them poorer in real terms – they push for wage increases ahead of the rate of inflation to maintain their standard of living. However, rising wages can make inflation worse.Companies that are paying higher wages will try to pass on these rising costs to their customers in the form of higher prices. As workers nominal income rises, this can also lead to an increase in consumer spending, which again can be inflationary.

Worker shortage a headache for the Fed

Despite tightening financial conditions for businesses, the US jobs market has been surprisingly robust. There has been upward pressure on wages because companies have found it difficult to get the right staff – and must pay more to secure and retain good employees.

There are numerous reasons for the shortage of workers. These include longer-term trends such as an ageing population, years of reduced immigration and a surge in early retirements. Indeed, the Covid-19 pandemic encouraged many older workers to stop working and there has been a reluctance to return to paid employment by many enjoying what they regard as a better quality of life by finishing working sooner than they expected.

The US added 209,000 jobs in June, slightly below market expectations of 225,000.

This is positive for the Fed – but the unemployment rate remained close to historic lows at 3.6% and wage growth over the month was stronger than expected too.

If the Fed were to ‘pivot’ in the next few months then there is a danger that the inflation villain is not dead, but merely wounded. Like the end of a horror film, the villain could return to wreak havoc once more – and inflationary pressures could easily return in 2024. The central bank needs to be reassured that the stake has been firmly hammered home and the current bout of inflation has been killed or at least locked away for good.

Although the Fed paused to take stock of its actions in June, other central banks around the world were surprisingly aggressive. The Bank of England and Norwegian central bank surprised markets with larger-than-expected increases, with Canada and Australia recently resuming their rate-hiking cycles. The actions of the latter two banks is a warning against over-optimism. Just because central banks start to pause at some meetings and this needs to be considered when it comes to the Fed. Sweden, Switzerland and the European Central Bank also continued to tighten policy in June.

The market optimists have placed their bets on a near term pivot because they do not believe the Fed will want to push the economy into a more damaging recession.

The market optimists have placed their bets on a near-term pivot because they do not believe the Fed will want to push the economy into a more damaging recession. However, concerns about a contraction in the US keep being pushed back, as the underlying economy continues to demonstrate significant strength.

Caution warranted

At Charles Stanley, we do not think that central banks have finished raising interest rates and expect them to stay “higher for longer” so those in charge at central banks can be clear their task is done. These institutions already stand accused of failing to spot the inflation problem building, so they will not want to leave the job of defeating it undone.

Fed policymakers are unlikely to consider a pivot until they see much slower total and core inflation. They will want to see a cooling in the jobs market – with a fall in job openings as companies preserve their capital and probably an uptick in unemployment to be sure that wage growth will continue to slow and stay below the level of overall inflation. This is likely to take some time, as they need to be convinced that the slowdown in inflation that is expected in 2023 does not give way to another jump in 2024. As a result, over the next few months, we need to be careful that we don’t get too optimistic too early that the inflation fight is done.

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Don’t underestimate the resolve of central bankers

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