Financial markets are pondering the US Federal Reserve’s likely policy path after last week’s release of another set of unexpectedly high inflation data and recent strong job market figures. It is a combination that could delay or even prevent it from cutting interest rates. The upcoming monetary policy meeting will be watched very closely.
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US inflation data was a major focus for markets last week, with February headline and core consumer prices rising respectively by 3.2% and 3.9% year-on-year (YoY). Prior to that, Fed Chair Powell’s testimony to Congress included a reference to the “relatively tight” labour market.
While it may look as if a tight labour market and inflation data could stymie hopes of a cut in interest rates, that may not necessarily be the case.
A strong labour market will not necessarily push up inflation if productivity rises as it appears to have done since the pandemic.
Interest rates and recession
The last time the Fed tightened policy aggressively without pushing the economy into a recession was between March 1994 and 1995 (Exhibit 1), when it raised rates by 300bp in response to concerns about rising inflation. In anticipation of policy tightening, the 10-year Treasury yield started to soar a few months beforehand.
This narrative is reflected in the more recent situation when the bond market started selling off in 2021 before the Fed started raising interest rates in early 2022. However, the hikes in official rates this time around have been more aggressive than in the ‘90s, totalling 525bp when the fed funds rate peaked in July 2023.
Today, as during the earlier tightening cycle, the US economy has withstood the pressure of rising interest rates. GDP grew by 3.2% YoY in the last quarter of 2023 and 2.5% over the full year; non-farm payrolls have recently increased by more than 200 000 a month (February payrolls grew 275 000, well above market expectations); and average hourly earnings rose by over 4% on an annualised basis in February, despite 15 months of tighter Fed policy.
Lessons learned
In the first half of the 1990s, the US economy and labour market were recovering from the savings & loan crisis. The unemployment rate fell to less than 4.5%, a rate considered below the ‘Non-Accelerating Inflation Rate of Unemployment’ (NAIRU) at the time. Fears about rising inflation prompted the Fed to tighten monetary policy.
However, inflation did not rise significantly (Exhibit 2). In hindsight, the Fed realised that the internet boom in the 1990s had powered strong productivity growth and kept inflation at bay, despite a robust labour market.
Today, evidence shows that US labour productivity has recovered strongly since the pandemic. This may explain why the US economy has remained resilient, with a strong labour market but receding inflationary pressures since mid-2022 (Exhibit 3).
Indeed, if the productivity gains can be sustained, the current pay growth of more than 4% should not provoke inflation. Structurally, the question is whether the positive disruption stemming from increasing use of artificial intelligence is powering a productivity boom this time around. Time will tell.
The Fed’s options
The relevance to today’s Fed policy is that, given its dual mandate of keeping prices stable and maximising employment, a strong labour market alone need not preclude policy easing if inflation does not rise on a sustained basis. Given current economic resilience, the Fed is not worried about growth. So, it is not in any hurry to cut rates.
Despite near-term volatility in consumer prices, both headline and core personal consumption expenditure (PCE) inflation have fallen to three-year lows of 2.4% and 2.8%, respectively. We expect inflation to continue to fall towards the Fed’s 2% target. If the economy remains resilient (despite commercial real estate stress), the Fed may recalibrate and opt for fewer rate cuts than the market currently expects.
Impact on other central banks
The Fed’s monetary policy affects other central banks mainly through the exchange rate channel. Given the divergence in growth momentum between Europe and the US, if the European Central Bank (ECB) cuts rates before the Fed does, the euro could weaken, which would likely constrain the ECB’s pace and frequency of interest rate cuts this year.
Across the Pacific, Asia is not expected to cut rates ahead of the Fed due to the region’s reliance on US dollar liquidity. We believe that if the Fed delays cutting, Asian central banks will follow suit, despite average inflation in the region already being lower than it is in the US. Exchange rate stability is a key consideration for the regional authorities.
The exception is Japan, where the central bank is widely expected to end its negative interest rate policy soon, taking it in the opposite direction to the Fed. If the Fed delays its rate cuts, it could put downward pressure on the yen, possibly even forcing the Bank of Japan to raise its policy rates to defend the currency.
Current wage negotiations in Japan could reinforce the rate hike pressure if they create a wage-price spiral. As reported last Friday (15 March), Japan’s biggest union group, Rengo, successfully negotiated a pay increase of 5.3% (from 3.8% in March 2023) for its members. This was significantly above market expectations of 4% and of a size not seen for 30 years.
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