The case is building for slower Fed tightening

Translation of an article published by L'AGEFI Hebdo on 3 November 2022
By Michala MARCUSSEN, Group Chief Economist

After engaging a pace of rate hikes not seen in decades, the Federal Reserve members are weighing up a shift to a slower pace of rate hikes against the need for further jumbo moves.

The case for a slower pace of policy tightening is supported by several arguments. Top of the list is that leading indicators for the US economy are pointing to a substantial slowdown and consensus is now looking for real GDP growth of just 0.4% in 2023. This compares to a consensus forecast for 2023 growth of 2.5% prior to the Russian invasion of Ukraine. Financial conditions have also tightened substantially, and with significant spillover globally. A further concern is that monetary policy feeds through to the real economy with lags of 1-2 years, and with uncertain impacts. The Federal Reserve is not only engaging aggressive rate hikes, but also reducing its holding of bonds, i.e. quantitative tightening. This likely adds to the uncertainty.

The advocates of further aggressive rate hikes point to disappointing outcomes to date in taming inflation and still tight labour markets. September inflation clocked in at 8.2% on the headline and 6.6% on the core (excluding food and energy prices), well in excess still of the level around 2% considered consistent with the Federal Reserve’s price stability. The September unemployment rate meanwhile stood at 3.5%, well below the 4.5% considered by the Congressional Budget Office to be consistent with full employment. Moreover, while financial conditions have tightened, the National Financial Conditions Index, compiled by the Federal Reserve Bank of Chicago, remains ever so slightly negative on both the headline and adjusted measures. As such, these indicators have yet to enter the positive levels historically associated with tighter-than-average financial conditions. On a final point, this camp notes that risking recession today may well be a price worth paying to avoid a higher cost down the road should inflation become entrenched.

Absent a sudden and sharp deterioration of financial conditions, the frontline of this debate is very much dependent on the economic data, and not least inflation and unemployment. Trouble is that both indicators lag the economic cycle. Historically the US has on several occasions entered recession with still low unemployment and high inflation. The details of both reports thus matter greatly in the monetary policy debate, and these could well be tilting in favour of a slower pace of rate hikes.

Turning first to inflation, the recent stabilisation of energy prices, if confirmed, should contribute help lower inflation quite substantially. Retail gas prices, at $3.76 per gallon remain just over 10% above the levels seen in last October. Coming into March 2023, however, the contribution from retail gas prices could well even turn negative absent a new severe price shock. A further dampening effect on inflation comes from the inventory channel, where several retailers in the United States have announced plans to discount stocks. This effect could become visible heading into the year-end holiday seasons.

Higher cost of financing and tighter bank lending conditions is also set to dampen inflation. Rent measures, both direct rent of primary residence and owner occupied equivalent, carry a weight of just over 30% in the US CPI measure. It thus comes as no surprise that the housing market trends are being closer watched. US house prices saw very significant gains during the pandemic, but the key S&P Case Shiller house price measure has recently posted monthly decline. Such turning point tends to lead the CPI rental components by around 1 year, and with further slowing of housing expected, this is yet a factor pointing to slower inflation ahead.

Turning to the labour market, the September employment report showed a strong headline with an unemployment rate of just 3.5%. There is no doubt that US labour markets remain tight but looking at the Job Openings and Labour Turnover data (JOLTS), the first signs of easing are appearing with the latest report showing a first decrease in openings. Survey data, moreover, show firms scaling back hiring intentions. The flash PMI for October saw the composite employment index fall below 50, the threshold between expansion and contraction, for the first time since June 2020.

Balancing these arguments the threshold to shift to a slower pace of hikes may well come soon but be warned that actual easing is likely to come much slower than seen in recent decades.