Fed Rate Hike Pause Still Likely Despite Strong Data

(June 2, 2023 - Howard Schneider)

WASHINGTON, June 2 (Reuters) - Federal Reserve officials, whose hike, skip or pause messaging on interest rates has become a high-stakes word puzzle for investors, seem ready to end the U.S. central bank's run of 10 straight rate increases later this month while leaving the door open to a future rise in borrowing costs.

For a central bank that says it is "data-dependent," the decision may be more complex than it wants, with the release on Friday of a May employment report that blew through expectations as employers added 339,000 jobs across a broad set of industries. Key inflation data since the last policy meeting also rose.

Yet a jump in the unemployment rate to 3.7% from 3.4% in the prior month, a slowing in the pace of hourly wage growth, and a decline in hours worked left investors and analysts still expecting the Fed to stay on hold for at least one meeting to look for more confirmation that either the economy is cooling or higher rates are warranted.

The U.S. central bank seems "inclined to skip tightening in June but could resume tightening in July. Today's strong employment readings support that action," said Kathy Bostjancic, chief economist for Nationwide.

Fed policymakers in recent weeks have tried hard to keep their options open, with those inclined towards more hikes acknowledging a case to hold steady, and those worried about higher rates acknowledging stubbornly high inflation may require them to slow the economy even further.

Amid those competing views of the world - one where inflation remains the dominant risk, one where the economy is about to buckle - officials at the Fed's June 13-14 meeting will in new economic projections have to give the sort of hard guidance through numbers that they've been reluctant to provide through words.

In particular the "dot plot" in the Summary of Economic Projections will show whether the majority of Fed officials, as they have since December, continue to see the current 5.00%-5.25% range for the benchmark overnight interest rate as adequate to lower inflation, or whether more now see higher rates as necessary regardless of the risk to an economy that may be losing steam.

If sentiment is leaning momentarily towards holding rates steady for now, the outcome is not a lock, nor will it signal what is likely to happen next.

"It's not clear to us that any of the ... participants who expected a 5.125% terminal rate in March have changed their minds," Tiffany Wilding, North American economist for PIMCO, wrote in an analysis. She also expects the Fed to keep its policy rate steady this month "while hinting at potential further hikes" as a way to compromise among different views and keep pressure on financial conditions.

Fed officials will enter a pre-meeting "blackout" period after Friday, with no formal chance to reshape market or household expectations as the final data reports for the inter-meeting period are released, most notably the Consumer Price Index data for May due out on June 13 as policymakers gather in Washington.

CANNOT RULE OUT A HIKE

At its May 2-3 meeting, the Fed approved its 10th straight rate increase since March 2022, but in doing so shifted tactics from a clear tightening path to a more ambiguous, "meeting-by-meeting" approach that in theory would allow incoming data to shape policy choices.

Left unstated is how reactive policymakers would be in the face of certain data points - stickier inflation, for example, or stronger-than-anticipated job growth in both April and May - and investor views of the outcome of the June meeting have been volatile as a result.

In the last two weeks, contracts tied to the federal funds rate have jumped from pricing in a rate-hike pause this month, to pricing in an increase, to, even after the jobs report, again seeing the Fed as likely to "skip" a hike at the upcoming meeting only to deliver one again in July, and then start cutting rates in November.

Fed Chair Jerome Powell and others insist that sort of erratic path is not their base case. The intent, rather, is to reach a "sufficiently restrictive" policy rate and remain there until it is clear inflation is falling towards the Fed's 2% target. Inflation is currently more than twice that level.

Economists, including veteran Fed watchers, are also divided between those who see inflation and the economy on the verge of a fast slowdown, those who see the central bank as still poised to hike given inflation's persistence, and a few who see the Fed managing aptly towards a "soft landing" in which the economy and inflation slow without triggering a recession.

Opinions have been shifting quick. The release of a Labor Department report on Wednesday that showed an unexpected jump in job openings weighed towards a rate increase given the Fed's focus on the strength of the job market; remarks by Fed Governor and vice chair nominee Philip Jefferson later that day tilted towards a pause when he said "skipping a rate hike at a coming meeting would allow the committee to see more data" before deciding if tighter policy was even needed.

For Larry Meyer, a former Fed governor who analyzes monetary policy for his Washington-based consulting firm, the jump in job openings "pushed us over the edge" to believe the central bank will raise rates again in June.

But "that doesn't mean we have great conviction" about the outcome, he wrote.

At the other end of the spectrum, Ian Shepherdson, the chief economist at Pantheon Macroeconomics, in a briefing this week checked off a laundry list of signs the economy is flailing, from weakening business investment to soured small business sentiment to a drop in real-time measures of things like restaurant dining, a proxy for the sort of services spending that may need to cool for inflation to fall.

Still, Shepherdson's Fed outlook was framed with a similar lack of certainty - a victory, in a way, for a central bank trying to avoid making promises.

"I do think they are done" with rate increases, he said, but "I cannot rule out another hike in June."