US data continues to suggest the Fed has done enough

Softer pricing and output data eroding the need for further monetary tightening

By Stuart Cole | @Stuart Cole | 4 July 2023

US data and fed 1

Market pricing continues to show an expectation for US interest rates to be raised again this month, an 84% probability currently assigned to the FOMC increasing rates by a further 25bps at its meeting on 26th July. However, our case remains that the Fed has already done enough to bring CPI back to target and that any further tightening in monetary policy will simply exacerbate the growing risk of the US economy slipping into recession; indeed we may already have passed that point. The most recent US data releases have all provided further weight to this argument, the latest PCE Deflator, Personal Spending and ISM numbers collectively showing inflationary pressures receding and economic activity slowing.

The monthly core index of Personal Consumption Expenditures, released last week, showed an increase of 0.31% in May, the slowest monthly pace of growth since November. The headline reading, ie including food and energy prices, rose by just 0.1%. However, of most significance is that the core PCE services reading ex rents – the Fed’s key measure of inflationary pressures – rose by 0.23%, its slowest monthly rate of growth since last July and extending the downwards trend that has been seen since the start of this year. Of course, it needs to be remembered that the series can be volatile and lower prints have a habit of being followed by higher numbers. But the underlying direction of travel is downwards, and if the evidence of slowing wages growth from the various business surveys conducted is assumed to be accurate – wages are typically the most significant cost component for the services industry – then, combined with the continuing falls being seen in global food and energy costs, core services prices should continue to fall over the remainder of the year, in turn removing one of the key justifications used by the 'hawks' on the FOMC when arguing the need for further monetary tightening.

Accompanying the PCE figures were the Personal Spending numbers, which reinforced the argument that at the same time as pricing pressures are easing, so consumption is also losing momentum. With last month’s real spending figure of 0.5% revised downwards to 0.2%, the reading for May printed at 0.0%, showing spending remained flat. On the basis that there are no surprises to the June reading, consumption over Q2 looks to be heading for a reading of around 1%, sharply lower from the Q1 reading of 4.2%. Admittedly, the Q1 reading was boosted by the unseasonably mild winter weather seen over large parts of the US which encouraged consumers to venture out to shopping malls and restaurants etc, and from the 8.7% uplift made to social security payments. As such, spending in Q2 was certain to undershoot to a degree. But the underlying picture is one of a weakening propensity to consume, and in an economy where consumption is responsible for generating some 70% of GDP, the consequences of this for overall growth are ominous.

Lastly, the most recent June ISM manufacturing index continued to paint a dismal outlook for US industry. The headline index fell from 46.9 to 46.0, the lowest reading since May 2020, continuing the downwards trend that has been seen since the Fed began hiking interest rates in March last year. And worryingly, the production subindex fell by 4.4 points to 46.7, a new low for this cycle, and pointing to further drops in manufacturing output going forward.

Ahead of the forthcoming FOMC meeting, the main pieces of economic data left to be published are the CPI, PPI and payrolls numbers. On the basis of the picture painted by the releases above, it is not unreasonable to expect them to show a similar picture of easing pricing pressures and cooling economic activity. With the full impact of the Fed’s interest rate increases delivered to date yet to be fully felt, the argument that the monetary tightening delivered so far is sufficient to engineer the slowdown in activity the Fed is seeking and to return CPI to target remains valid. However, if the scars of the Fed’s experience in getting the ‘transitory’ inflation argument so wrong cause it to raise rates again this month, it will almost certainly be the last hike delivered in this cycle - and will simply bring forward the expected reversal in policy as the Fed is forced to change tack in favour of supporting growth again.

The US economy may already have passed the point where a recession is unavoidable