Fed turns the tide in war on inflation, but it’s too early to declare victory

There has been something for everyone in the recent economic data from the US. Rate hawks concerned about inflation and a tight labour market can point to a fall in the unemployment rate to 3.5%, close to the lowest level on record. Meanwhile, doves looking for evidence that the Federal Reserve (Fed) has already done enough will highlight the moderation in payroll growth and average hourly earnings, alongside a fall in job openings. Upward revisions to the weekly initial unemployment claims figures add to the case that the labour market is responding to tighter monetary policy.

However, whilst the labour market is showing signs of cooling it remains hot. The number of job openings has fallen below 10 million, but with just under six million unemployed the ratio of openings to applicants is historically high at 1.7. Likewise, initial unemployment claims may have moved up, but at around 200,000 they are well below the levels associated with a loose labour market.

The labour market is headed in the right direction, but needs to slow considerably further to turn the direction of policy. Judging from the Fed’s latest projections from the 21-22 March meeting of the Federal Open Market Committee this would mean an unemployment rate of at least 4.5%, one percentage point (pp) above current levels.

At the same meeting the Fed also discussed the problems in the banking sector and the potential impact of tighter credit conditions on the economy. As chair Jerome Powell remarked in his post meeting press conference, these events are the equivalent of at least one hike in rates and led the Fed to dial back on a bigger rise in March.

Markets have stabilised since then and fears of a credit crunch have receded. Alongside the continuing tight labour market, this might encourage the Fed to revert back to a more aggressive tightening path. We would note though that despite more benign financial conditions, the actual bank lending numbers are weak with loans to business, real estate and consumers all decelerating sharply over the past three months.

Although the failure of SVB and other regional banks will have played a role, the origins of the weakness in lending began earlier as banks had been tightening credit conditions for some time. The Senior Loan Officer survey showed a considerable tightening and fall in demand for loans in all these areas back in January this year.

This supports our view that although the problems in the banking sector have idiosyncratic causes they are also a symptom of monetary tightening impacting the economy. They are a classic sign that policy is biting. As the IMF indicated at their current gathering, we should be wary of treating recent bank failures as isolated incidents.

Meanwhile, inflation is falling as headline CPI edged up just 0.1% in March after a 0.4% rise in the previous period, dragging the annual comparison down from 6% to 5%. However, the softening was almost entirely due to the food and energy categories, with food prices flat and gasoline prices falling 4.6% over the month.

Taking these out of the equation, underlying inflation remained firm. Core inflation rose by 0.4%, broadly unchanged from its pace over the prior three months. Much of this stickiness has been concentrated in the rent of shelter category, which comprises 40% of core CPI. This is moderating, albeit slowly given the infrequency at which rents are negotiated.

To get a better gauge of domestic price pressures, our preference is to focus on core services less rent of shelter given how closely it tracks labour market conditions. Whilst an admittedly noisy and narrow-based measure, it has trended down since the middle of last year and is now running at around 4% on a three-month annualised basis.

Even so, along with the tightness of the labour market this is likely to be uncomfortably high for the Fed. Barring another major bank failure we expect policymakers to focus on inflation and raise rates by another 25 basis points at their next meeting on 3 May. Beyond this, if the recent softening in labour demand is sustained as we expect then inflation should moderate more convincingly, reassuring the committee that further policy tightening is not required.