Fed raise interest rates, but a pause is still on the cards

Last week the Federal Reserve (Fed) raised interest rates as expected, albeit at a slower pace, and continued to steer markets towards further interest rate rises. However, financial markets have started to anticipate a pause in the US Central Bank’s rate rises. Are they right? There is increasing data to support their optimism.

The Fed guided towards a 25bps interest rate rise in this meeting and the next. It maintains its tough talk on the importance of price stability. However, data emerging from the regional reserve banks paints a different picture and may ultimately prompt a pause in interest rate hikes. There have been five pieces of evidence that are of particular interest.

1. A statistic from the St Louis Fed

One statistic from the St Louis Fed looks at the number of US states with increasing activity, with ‘activity’ defined by elements such as non-farm payrolls, real wages, hours worked in manufacturing and the jobless rate. This ‘coincidence state’ index shows that around half of the 50 US states are showing declining activity. This is a strong signal for recession.

2. Labour figures from the Philadelphia Fed

These figures give an alternative view to the national statistics. They showed there were only 10,500 net new jobs created in the second quarter of 2022, rather than the 1.1 million estimated by the aggregate data.

3. The Cleveland Fed introduced a new data set looking at rents

Rents are an important metric for the Fed, but its current measure is based on contract rents, surveyed every six months. This doesn’t give a clear picture on spot rents, which better reflect the current market. The new data set teases out spot rents and shows them coming down sharply. This suggests the Consumer Prices Index (CPI) is likely to decelerate further over the coming quarters.

4. The relationship between inflation and consumption

Another data point that also comes from the St Louis Fed, looks at the relationship between inflation and consumption. Unsurprisingly, this shows a clear relationship between stronger consumption and higher inflation. However, when the impact of the pandemic is disaggregated, it shows that the current inflation hasn’t been accompanied by a big boom in consumption. This demonstrates that factors other than growth in demand are driving inflation, notably supply disruption and government spending. If inflation isn’t demand led, raising interest rates more aggressively won’t help bring it under control.

5. Demand-driven inflation is missing

This is supported by statistics from the San Francisco Fed, which breaks inflation into demand-driven and supply-driven elements. Data from November shows there was no demand-driven inflation (month-on-month basis).

Of course, there are risks to the view the Fed may pause sooner rather than later. Core inflation, which excludes energy and food costs, remains sticky. Until it shows clear signs of deceleration, the Central Bank may be reluctant to pause on raising interest rates.

There is also the risk that wage rises become entrenched. Last week’s jobs report, from the Bureau of Labor Statistics, provided a major upside surprise, with non-farm payrolls gaining a massive 517,000 – almost 330,000 more than the consensus expectation. We caution against reading too much into this headline figure because a series of methodological changes were made. But still, the labour market continues to look resilient, though there are initial signs that wage growth is decelerating. A final risk is that there has been a loosening of financial conditions over recent months. Fed Chair Jay Powell has been clear that he doesn’t want looser financial conditions as it makes the Fed’s job harder.

On balance, we view that the Fed is likely to pause interest rate rises earlier than its rhetoric suggests. US inflation may be decelerating faster than the headline data suggests and ultimately, the central bank will want to avoid a hard landing for the economy.