US inflation, jobs report show Fed can’t just stick to autopilot on interest rate rises

Robust economic data, stubborn inflation, easing fears of a banking crisis and the end of the debt ceiling drama all give the Fed room to raise rates again
Other leading indicators are flashing signs of caution, though, and the Fed must be mindful not to be too aggressive and risk harming the economy

Tai Hui

Published: 9:15pm, 9 Jun 2023

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The US Federal Reserve will next meet on June 13-14 to discuss monetary policy. For the first time since the rate-raising cycle began in March 2022, the discussion is likely to revolve around whether to stop raising interest rates.

Economic data, the vulnerability of the banking sector and the US government debt ceiling saga all influence the decision. The Fed could opt to leave rates unchanged – but there is a growing probability that this would just be a pause, rather than the end of the increases.

The Fed Funds futures market, which reflects investors’ expectations of what the central bank will do in the months ahead, has swung wildly in recent weeks. Not only has this indicator shifted on whether rates will rise in the coming months, investors also seem to have changed their minds about whether the Fed will cut rates later this year.

After the May Federal Open Market Committee meeting, the futures market was pricing in the end of the rate-raising cycle. It expected the Fed to start cutting rates in the second half of the year, with a total reduction of 100 basis points by next January. However, as of June 2, the same market pricing is showing an 80 per cent chance of another 25-point rise by the July meeting, with the first cut delayed until December.

What has changed? The troubles surrounding US regional banks seem to have stabilised. This has helped calm investor nerves about a possible banking crisis. Moreover, recent inflation and economic data are still showing considerable resilience.

April’s personal consumption expenditure price index was up 0.4 per cent month on month, showing that the Fed’s inflation concerns are not over yet, especially in the service sector. Employment numbers for May were much stronger than expected, with 339,000 jobs created versus a market expectation of just 195,000. Figures from April were also revised higher.

An advert for jobs is seen in the window of a Chipotle restaurant in Los Angeles on June 6. The US economy added 339,000 jobs in May despite the Fed’s aggressive interest rate rises in an attempt to lower inflation. Photo: EPA-EFE

This shows the limited cooling effect of higher interest rates on inflation and demand for workers, which could encourage hawkish Fed officials to advocate for more rate increases. The Fed’s own assessment of the economy, known as the Beige Book, also painted a stable economic picture, even though businesses expectations are turning more cautious.

The conclusion of the debt ceiling drama also means the Fed can return its focus to fighting inflation. President Joe Biden and House Speaker Kevin McCarthy agreed on a bill to raise the debt ceiling until January 2025. The economic impact of the spending cuts in the bill is likely to be limited, and the speed with which the legislation went through Congress will limit any short-term damage to the US economy and financial stability.

Given the reduced risk of a banking crisis and a government default, as well as robust economic data, why shouldn’t the Fed raise rates? Instead of proceeding on autopilot, as it has done for the past 15 months, there are several factors the Fed needs to consider.

The draft of a bill that US President Joe Biden and House Speaker Kevin McCarthy negotiated to raise the nation’s debt ceiling is seen on May 30. Photo: AP

Policy rates have already risen rapidly over the past 15 months, and few central bankers would disagree that we are already in restrictive monetary policy territory. Looking at the March Summary of Economic Projections, which collated forecasts on the economy and policy rates by senior Fed officials, 10 out of 18 officials predicted policy rates would remain at the current level until the end of 2023 while only seven forecast that rates would end the year higher.

While this could still change in the June update, these forecasts suggest most officials believe the end of the rate-raising cycle is near.

Even as economic figures, especially the job market and consumption, still show considerable signs of resilience, other leading indicators are flashing signs of caution. In particular, banks are consolidating lending standards either because they are constrained by deposit outflows or because risk managers are becoming more prudent due to the economic outlook.

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This tightening, which began in late 2022, has in the past been a reliable indicator of a recession in the US, and the Fed should be mindful that its actions do not lead to a sharp economic contraction.

High interest rates, after all, don’t break things right away – there is a time lag, and policymakers will need to think not just about the next few months but also further ahead, to gauge the right level for interest rates.

So, it would make sense for the Fed to be more prudent in future tightening, instead of just automatically raising rates in reaction to the current data.

Tai Hui is chief market strategist for the Asia-Pacific at JP Morgan Asset Management