Does the Fed’s Pause Finally Mean Mission Accomplished?

Fed Takes a Break

For the first time in 15 months, the Federal Reserve (Fed) held interest rates steady on June 14. Lingering concerns about banking industry stress contributed to the decision to keep the short-term rate target in a range of 5% to 5.25%.

The Fed has been on a rate-hike rampage, facing persistently high consumer prices that threaten its inflation-fighting credibility. Taking a break finally gives policymakers time to assess the lagging effects of the fastest-tightening campaign in 40 years. It also allows the Fed to gauge the health of the broad banking industry and the state of credit creation.

Fed’s Hawkish Outlook May Not Last

Fed Chair Jerome Powell’s relatively hawkish tone during his June 14 press conference left the door open for additional tightening. But we don’t believe more rate hikes will be necessary. Recent inflation, wage growth and other economic data indicate the Fed’s efforts are working.

Headline Inflation Retreats

Former Fed official Esther George recently confirmed that while the Fed considers various economic indicators, none is as influential as inflation data. The Federal Reserve Bank of Kansas City’s former president took viewers inside the Fed’s dilemma during an American Century webinar.

Since June 2022, the annual headline inflation rate has moderated. The latest reading showed a drop from 4.9% in April to 4% in May, as energy prices plunged. Headline inflation growth now stands at less than half its June 2022 peak of 9.1%.

Core inflation (minus food and energy costs) growth also has eased, though slowly, since peaking at 6.6% in September. The annual core inflation rate fell from 5.5% in April to 5.3% in May, still notably higher than the Fed’s 2% target. Stubbornly high services costs, fueled mainly by rising shelter costs and a resilient labor market, have been key culprits.

Labor Market Data Mixed, While Wages Slowly Soften

The May jobs report featured a robust 339,000 gain in nonfarm payrolls, highlighting persistent inflationary pressures. In addition, the Bureau of Labor Statistics revised upward the payroll data for March and April. However, it’s important to note that large revisions to job figures may occur at business cycle turning points.

Conversely, the separate (and smaller) household employment survey indicated a sharp drop in employment, which lifted the unemployment rate to 3.7% from 3.4% in April. The divergence likely was due to a sharp decline in self-employed Americans, captured in the household survey but not nonfarm payrolls.

Meanwhile, wage growth, another key driver of rising inflation, appears to be slowly softening. After peaking at an annualized rate of 6.7% in June 2022, wage growth steadily slowed to 6.0% in May.

Tighter Credit Conditions Aid Fed’s Efforts

Although the economy and inflation haven’t yet slowed to the Fed’s liking, a potential credit crunch has put policymakers on guard. Following several high-profile bank failures, the banking industry remains stressed and under scrutiny.

Financial firms began reining in their lending activity in the first quarter, well before markets realized the full effects of the bank failures. The Fed’s April Senior Loan Officer Opinion Survey on Bank Lending Practices showed that most banks implemented tighter standards for business and consumer loans.

We expect a continued slowdown in lending activity, which would further help the Fed achieve its goals. As the pullback in credit creation filters through the economy, job growth, consumer spending and inflation should continue to temper.

History Offers Clues to Tightening Cycles

It’s important to note that at its current range of 5% to 5.25%, the Fed’s short-term rate target remains higher than the headline inflation rate. This has proved to be a key metric in ending hiking cycles dating to 1973, as illustrated in Figure 1.

Figure 1 | Peak Rates Have Consistently Topped Inflation

^{Data as of 6/14/2023. Sources: FactSet, Bianco Research LLC. *If rate hikes ended 6/14/2023.}

Additionally, in the past 50 years, the Fed always ended a tightening campaign when the real federal funds rate (federal funds minus headline inflation) was positive. The most recent tightening cycle (highlighted in Figure 2) shows that the real federal funds rate turned positive earlier this year. We believe this dynamic further supports our view that the Fed’s target lending rate has likely reached its peak.