Has this month's FOMC meeting seen the Fed make a mistake with monetary policy?

This month’s (12th June) FOMC meeting left interest rates unchanged, as was widely expected. With this decision therefore put to one side, the key significant take away from the meeting was that the Fed now expects interest rates to be cut only once this year, down from the three cuts that were expected at the March FOMC meeting. Indeed, the ‘dot plot’ shows that four members of the Committee do not envisage any cuts being made this year at all. Given the economic data now emerging, showing disinflationary forces to be strengthening once more and the pace of economic activity slowing, we suggest the Fed has made a mistake with this hawkish tilt and that, if the economy over the remainder of 2024 pans out as we expect, more than once 25bps cut will be delivered before year-end.

The possibility of the Fed reducing the number of interest rate cuts expected this year had already been flagged by Equiti Capital (https://www.equiti.com/sc-en/news/breaking-data/us-inflationary-pressures-continue-to-weaken-in-may/) when, following the release of the May CPI numbers (12th June), we suggested the subsequent FOMC meeting would see the number of cuts expected this year reduced from three to two; the decision to expect just one cut surprised us. Clearly this is an aggressive move by the Fed and suggests that, despite Powell asserting at the FOMC press conference that “modest further progress” had been made in bringing CPI back to target, the Fed remains worried that the inflationary “bumps in the road” seen in the Q1 data could yet turn out to be more structural.

But this move is puzzling, given that the FOMC meeting revised the 2024 forecast for core PCE up by just 0.2%, to 2.8%, implying that the Committee expects monthly PCE readings over the remainder of the year to match those seen over H2 2023, rather than the much stronger prints seen so far this year. Clearly the FOMC is expecting inflationary pressures to weaken going forward. And this expected weakening was very much seen in the PPI numbers for May (13th June), which added to the growing body of evidence showing disinflation to be once more in the ascendancy, with the key PPI services ex-trade services component (ie retail margins) falling by 0.1%, the first negative print since April 2020 and significantly lower than the average 0.5% monthly readings seen so far this year. Even the retail margins component, while still elevated compared to pre-covid trends, fell by 0.7% y/y, and as the strength of consumer demand slows, can be expected to continue falling.

So with the inflationary outlook looking so benign, the question arises of whether it is the labour market that is responsible for yesterday’s hawkish tilt? And it appears that it is here that the answer can be found. Despite similarly growing evidence that the demand for labour is weakening, the Fed opted to keep its forecast for the rate of unemployment this year unchanged at 4.0%. This is very much at odds with forecasts in the wider market, which expect to see the rate climb to around 4.5% by year-end. The Fed has chosen to ignore items such as survey evidence showing hiring intentions to be slowing, or the deterioration being seen in the Current Population Survey (aka the Household Survey), or the growing jobless claims numbers (which have been on a rising trend since mid-Q1 and are generally a lagging indicator of the health of the labour market) or even the growing size of the labour force, which is expanding once more as levels of immigration recover after Covid. But perhaps most startling is that the statement by the Bureau of Labour Statistics this month, which said it may have over-estimated the strength of payrolls growth by an average of 60k positions each month last year, has been seemingly over-looked.

It is difficult to also suggest that the Fed remains overly worried by the strength of wages growth, given the evidence showing that downwards pressure on wages is similarly growing, as very much evidenced by the ‘Quits’ rate falling back to pre-covid levels.

Overall, our suggestion is that what we are seeing is the practical implications of a Fed that remains exceedingly risk averse; having got the ‘transitory’ inflation argument so wrong it is simply unwilling to take any chances at all with losing control over inflationary pressures again, even if that means keeping interest rates too high for too long and in turn unnecessarily dampening down economic activity more than is needed. However, with the labour market expected to materially weaken going forward and inflationary pressures to continue to soften, we expect the FOMC will be forced to cut rates sooner than it is currently expecting – our forecast remains for a first cut to be delivered in September – and that over Q4 it will need to cut rates further if it is to prevent itself from falling too far behind the policy curve.