The pause that refreshes
The Fed may be done hiking, but its subsequent pause could last awhile.
Over the Federal Reserve’s last eight rate-hiking cycles—spanning half a century—the central bank consistently has raised its fed funds rate to a level above inflation before pausing. We’ve finally achieved that relationship again, as the Fed has diligently struggled to reduce the worst inflation in more than 40 years. Last week, policymakers hiked rates the tenth consecutive meeting, lifting them by a quarter percentage point to a target range of 5-5.25%, the highest in 16 years. On Wednesday, nominal CPI inflation inched down to a 4.9% y/y increase for April from 5% in March.
With the fed funds rate now above the inflation rate, it appears this is an appropriate time for the Fed to forgo a hike at its meeting on June 14. Given the elevated and sticky nature of inflation, that pause might last into 2024. That’s an out-of-consensus view, to be sure, as the market projects that after pausing next month, the Fed will cut rates in each of its last four Federal Open Market Committee meetings of this year.
How do we square that circle? The market still harbors visions of “Immaculate Disinflation” and “Immaculate Pivot,” assuming the economy will weaken so sharply the Fed will be forced to come off the sidelines to easing policy.
To complicate this calculus, the Fed isn’t looking exclusively at the prospective pace and trajectory of the decline in inflation. Officials expect that the recent banking industry stress—and the resultant tightening of bank lending standards and reduced loan volume—could function as a pseudo 50 basis-point hike. In addition, Washington’s intransigence on raising the debt-ceiling adds pressure to the Fed’s summer deliberations.
Turning our attention back to the economy, it appears to us that while inflation has declined over the past several quarters, the easy money has been made. Further progress toward the Fed’s 2% target will be much more difficult. We expect the Fed to exercise patience.
Personal Consumption Expenditures index PCE declined from a 41-year peak of 7% last June on a nominal y/y basis to 4.2% in March 2023. Core PCE (the Federal Reserve’s preferred measure) slowed to a 4.6% y/y rate of growth in March 2023, down from 4.7% in February and from its February 2022 peak at 5.4%, a 39-year high. In its Summary of Economic Projections in March, the FOMC projected that core PCE will hit its 2.1% target by the end of 2025. Inflation continues to slow gradually, but it likely will be more than two years before the Fed can confidently declare victory.
Consumer Price Index Nominal retail CPI spiked from 1.4% y/y in January 2021 to a 41-year high of 9.1% in June 2022, but it has since fallen to 4.9% in April 2023. The core CPI (which excludes food and energy prices) declined from a 40-year high of 6.6% last September to 5.5% in April 2023.
Producer Price Index Nominal wholesale inflation hit a record 11.7% y/y in March 2022, but by April 2023 it had plummeted to 2.3%. While core PPI (which strips out food and energy) soared from 1.9% in January 2021 to a record 9.7% in March 2022, it has declined considerably to 3.2% y/y in April 2023.
Energy costs Gasoline prices at the pump soared 123%, from $2.25 per gallon in January 2021 to $5 in June 2022. But the Federal government liquidated half of its Strategic Petroleum Reserve over the next six months heading into the midterm elections, driving gas prices down 38% to $3.10 per gallon in December 2022. The government needs to refill the 350 million barrels it removed, and without continued liquidations, gas prices have rebounded 20% to $3.70 in mid-April.
Cleveland Fed Inflation Nowcast CPI This estimate incorporates daily oil prices, weekly gasoline retail prices and monthly consumer prices. The y/y nominal and core estimates for May are 4.1% and 5.3%, respectively.
Employment Cost Index It rose by a hotter-than-expected 1.2% quarter-over-quarter (q/q) in the first quarter of 2023, just off the record high of 1.4% growth in the third quarter of 2022. In the 27-year history of this metric, employment costs rose an average of 0.72% q/q, so they are running more briskly than the Fed would prefer.
Nonfarm productivity This important data point unexpectedly declined 2.7% q/q in the first quarter of 2023, compared with a 1.6% increase in the fourth quarter of 2022. Over the past 80 years, productivity growth has averaged 2.2% per year, so the current productivity of the U.S. workforce is running substantially below par.
Unit labor costs They soared by a higher-than-expected 6.3% q/q in the first quarter of 2023, versus a 3.3% gain in the fourth quarter of 2022. Over the past 80 years, unit labor costs have grown at an annual average rate of 2.9%, so labor costs are running more than twice as fast as their historical trend, in part because of the collapse in productivity growth over the past few years.
Average hourly earnings Earnings surged in the government’s most recent establishment survey by a hotter-than-expected 0.5% month-over-month (m/m) in April 2023 (which annualizes to a 6% run rate), up from a 0.3% m/m gain in March. Wages grew at a faster-than-expected 4.4% y/y pace in April 2023, up from 4.3% in March. In the limited 16-year history of this metric, wage growth has averaged 3% annually.
ADP private payroll survey In its most recent April 2023 national employment report, the annual pay for “job stayers” rose 6.7%, while the annual pay for “job changers” surged 13.2%.
Atlanta Fed’s Wage Growth Tracker This measure of the nominal wage growth of individuals employs microdata from its current population survey. It is running at 6.1% y/y in April 2023.
Union wage pressures could exacerbate inflation Much like Paul Volker more than 40 years ago, this probably is the last thing that Fed Chair Jerome Powell wants to see in his quest to achieve 3% wage growth. Companies typically pass higher wages onto customers in the form of elevated prices.
- Rail workers Last September, 13 unions received a 24% wage increase over five years from 2020 through the end of 2024.
- West Coast port workers 22,000 employees in 29 West Coast ports have been operating without a contract for the past year and may strike at any time.
- Delta Airlines Its pilots union received 34% raises spread over four years.
- American and United Airlines Management teams at both companies have pledged to match Delta’s industry-best wage package for their pilots.
- United Auto Workers This union representing 150,000 workers at General Motors, Ford and Stellantis just elected a new president, who has pledged a strike for the first time in four years. On the agenda are increased wages, benefits and COLA’s and job security in the wake of the industry’s planned transition to electric vehicles.