Will Fed Surprise the Markets?

Federal Reserve Chairman Jerome Powell faces a challenging situation as the interest rate decision approaches this Wednesday. Finding himself caught between a rock and a hard place, Powell must navigate the delicate balance between avoiding a credit crisis, which requires flexible monetary policy, and combating high inflation, which calls for the opposite approach.

Inflation dynamics: A crucial factor in the Fed's decision

Inflation, the key player in the Fed's decision-making process, may provide some support for the central bank's aspirations to the monetary policy cycle. The anticipated slowdown in inflation could provide the Fed with more justification to stick to its plan of temporarily halting the tightening of monetary policy. Several factors may contribute to a potential slowdown in inflation:

- The rise in the unemployment rate to 3.7% suggests the possibility of a calming effect on inflation, in line with the economic theory known as the "Phillips curve."

- Headline CPI inflation is expected to drop significantly in May, with projections pointing to a decrease from 4.9% to 4.1%. Similarly, core inflation is expected to decline from 5.5% to 5.2%. This sharp drop is primarily attributed to large negative base effects resulting from the oil price surge that began last year after Russia's invasion of Ukraine. Furthermore, if WTI prices remain below $70 per barrel, inflation may continue to decrease in June and July.

- Lower demand for commodities is likely to exert downward pressure on commodity prices following two months of elevated inflation. Commodity prices are projected to decrease to 0.4% compared to the previous 0.6%.

- Inflation for basic services is expected to decline to its slowest monthly pace since September 2021, primarily driven by easing rent inflation. Shelter costs, on an annual basis, likely peaked at 8% in May and are expected to gradually decrease to around 6% by year-end.

Powell's possible "hawkish pause" and revised interest rate projections

Should inflation figures released prior to the Fed's meeting confirm a decline to, or near, the projected 4.1% level, Jerome Powell could seize the opportunity to pause the interest rate hikes. Powell might refer to this move as a "hawkish pause," indicating that the Fed will carefully monitor inflation data and, if necessary, resume the path of interest rate increases should inflationary pressures resurface. This sentiment could be reflected either in the "dot plot" of Fed members' expectations or in Powell's tone during the subsequent press conference. Consequently, the projected final interest rate for the end of 2023 may be revised upwards to 5.3%, compared to the previous estimate of 5.1%.

However, it is important to note that a decision to pause interest rate hikes may not be unanimous among the Fed's members. Minneapolis Fed President Neel Kashkari and Fed Governor Michael Bowman may express support for further rate increases, potentially creating dissent within the central bank.