In the wake of the banking related turmoil in March, markets have regained stability since the start of April. Attention is now turning to prospects for monetary policy in the US and Europe. After an unprecedented round of policy tightening, the Federal Reserve and ECB are now focused on completing the cycle of rate increases to ensure price stability without undermining financial stability.
Early signs of weakening US labour demand
US jobs growth slowed in March, but not by enough, in our view, to deter the Federal Open Markets Committee (FOMC) from proceeding with another interest rate increase at its next policy meeting on 2-3 May.
In March, the US economy added 236 000 new jobs, in line with consensus forecasts. While this is a fall from the (upwardly revised) 326 000 positions added in February and 472 000 in January, job creation at this rate is likely to maintain upward pressure on wages.
Wage growth has remained firm in the US, with average hourly earnings rising by 0.3% in March after a 0.2% rise in February. On a year-on-year basis, wages have increased by 4.2%. Although this is lowest rate of increase since mid-2021, it is well above the level that would equate with the Fed’s target of 2% inflation.
Currently, the US job markets remains strong with an average of 334 000 monthly job gains over the past six months. The unemployment rate now stands at 3.5%, close to a multi-decade low.
Slowing, but not enough to stop the Fed
This US jobs report comes on the heels of recent data suggesting that the Fed’s 450bp tightening of monetary policy in 2022 is starting to weigh on this historically strong labour market.
Data for US jobless claims, tracking new applicants for unemployment benefits, came in higher than expected for March with the number of new claimants over the last 12 months also being revised significantly higher by the Bureau of Labor Statistics.
A separate report showed job openings dropped sharply in February. Overall, the message that we take away from this data is that the Fed is likely to raise the federal funds rate by 25bp in early May, from the current level of 4.75-5% with no rate cuts likely until 2024.
Markets, however, continue to price rate cuts in fourth quarter of 2023.
Data shows US inflationary pressures remain
Although inflation eased in March to its lowest level in almost two years, a rise in core prices further underscore to us the case for the Fed to tighten policy further.
Data published on 12 April showed the consumer price index (CPI) for March rose by 5% year-on-year. That marks a significant deceleration from the 6% rate recorded in February and is the lowest reading since May 2021. On a monthly basis, consumer prices increased by just 0.1%, slightly less than expected.
However, US core CPI, excluding volatile energy and food costs, rose by 5.6 % YoY after a 0.4 % rise, suggesting price pressures for some goods and services are still high. Along with the jobs report, this inflation report is one of the most important economic releases ahead of the Fed’s policy meeting in early May.
Fed officials do not yet appear to have forged a consensus over whether another quarter-point rate rise is necessary before the central bank can call an end to its historically unprecedented tightening of monetary policy to contain high inflation.
The economy remains exposed to the risk of a credit crunch in the wake of the recent US bank failures. Prior to the banking turmoil, most FOMC members backed an additional increase, to take the fed funds rate to above 5% and forecast no cuts until 2024.
That is in sharp contrast with current market pricing, which suggests the Fed will deliver one more rate rise next month before reversing course and cutting the funds rate this year.
In March, a broad-based drop in energy prices and an easing of food-related price pressures contributed to a more moderate increase in overall CPI.
Underlying the increase in the core measure was a jump in housing-related costs, with the shelter index rising by 0.6% for an annual increase of 8.2%. That corresponds to a deceleration from a 0.8% increase in February, suggesting a softening in this category is under way.
This is important because the shelter category has been among the biggest drivers of inflation for some time. In this latest report, it was cited as by far the largest contributor to the overall figure, more than offsetting the big decline in the energy index.
As the shelter index typically lags changes in home and rental prices by about a year, we see it as significant in suggesting a downtrend in shelter inflation is now under way.
ECB approaches the peak
In Europe, where there appears to be less risk of disinflation in the wake of the US banking turmoil, investors are pricing in a more hawkish path from the European Central Bank with markets pricing a probability of around 60% of a 25bp rate rise and a 30% probability of a 50bp rise at the next policy meeting on 4 May.
In recent days, policymakers do seem to be more aligned in suggesting a 25bp rate hike will be necessary in May. The ECB has raised rates by at least 50bp at six consecutive meetings — the fastest pace on record – to combat inflation, but eurozone core inflation pressures still show little sign of slowing.
ECB Governing Council member Francois Villeroy de Galhau was quoted on 12 April as saying the peak in rates is in sight with the ECB’s deposit now at 3%, a level that restricts economic growth.
April inflation data and the ECB’s quarterly bank lending survey, both of which are due two days before the May policy meeting, may well prove to be decisive in determining whether a seventh rate increase of at least 50bp is required.
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