Fed set to pause tightening cycle

Emily Nicol
Chris Scicluna

Fed set to pause tightening cycle this week
The conclusion of this week’s Fed’s FOMC policy meeting on Wednesday is widely expected to see interest rates unchanged. The May FOMC meeting saw Chair Powell suggest that a pause in the tightening cycle might be appropriate to take stock of recent economic and financial market developments, as well as the lagged effects of the cumulative tightening. Admittedly, the strong payrolls numbers raised expectations that further tightening would be required in due course. But other details of the report, including the slowdown in wage growth, were consistent with a slight easing in labour market tightness, while last week’s ISM surveys were notably weaker and initial jobless claims were significantly higher. So, in the absence of a significant upside surprise to tomorrow’s CPI report, Daiwa America economist Lawrence Werther expects the Fed to keep the Fed Funds Rate target range at 5.00-5.25%. The FOMC’s updated economic forecasts and dot-plot will be closely watched for signals on the likely near-term policy path, with the median expectation for the FFR for this year (and likely next year) likely to be revised slightly higher from the 5.00-5.25% (and 4.25-4.50%) projection previously published in March.

ECB expected to raise rates by a further 25bps, and signal more tightening to come
The ECB’s Governing Council decision on Thursday looks straightforward, with recent public comments from President Lagarde and other key policymakers having made clear that interest rates will be hiked further. So, having slowed the pace of rate hikes to 25bps in May, another increase of that magnitude in all main interest rates – taking the deposit rate to 3.50% – seems inevitable. In terms of the ECB’s balance sheet, the Governing Council will confirm that reinvestments of the proceeds of maturing APP securities will cease from the start of July.

The ECB will also publish updated macroeconomic projections at this week’s meeting. Given the downward revisions to euro area GDP to a mild recession at the turn of the year, we expect the ECB to revise down its full-year GDP forecast for 2023 (currently 1.0%), perhaps by about 0.3ppt, and its forecast for 2024 (currently 1.6%) more marginally. The downside surprise to the flash May estimate of inflation means that the ECB’s forecast of 6.0%Y/Y for Q2 looks broadly on track. And given the steeper than expected drop in wholesale energy prices, signs of a softening in food inflation, stronger euro exchange rate and slightly weaker GDP outlook, the ECB’s headline inflation projection of 5.1%Y/Y over 2023 as a whole could well be nudged lower. However, despite evidence of a further cooling in global goods prices, the Governing Council’s hawks will remain concerned about stickiness in core prices, particularly in services where price momentum still appears strong. So, while it will continue to insist that policy will be data-dependent, the Governing Council’s forward policy guidance is likely to signal that a further hike of 25bps is expected to come in July, but that the path for rates thereafter will be guided by the following set of macroeconomic projections due in September.

BoJ to leave unrevised its yield curve control framework
Given the improvement in the functioning of the JGB market over recent months, possibility of a snap general election over coming weeks and Governor Ueda having repeatedly warned of the costs of prematurely tightening policy, the conclusion of the BoJ’s Policy Board meeting on Friday seems highly likely to see the key policy parameters of its Yield Curve Control framework, as well as the negative policy rate, unrevised. But while the statement might well refer to a stronger inflation outturn over recent months than previously anticipated, it will also again state that achievement of the 2% inflation target would need to be accompanied by higher wage growth to justify an adjustment to policy. So, the BoJ will also leave intact its forward guidance, still committing to continue expanding the monetary base until inflation exceeds the 2% target in a stable manner, and reiterating (perhaps with less conviction) that it won’t hesitate to take additional easing measures if necessary.

Economic data

A relatively quiet start to the week for global economic releases brought the overnight release of the Japanese goods PPI data for May. Producer prices fell a steeper-than-expected 0.7%M/M, the biggest drop since April 2020, principally reflecting a sizeable drop in the price of electrical power and gas supply,. This left the annual PPI rate down 0.8ppt to 5.1%Y/Y, the lowest rate since June 2021 and down from the peak of 10.6%Y/Y in December. Strikingly, prices of imported goods were down 5.4%Y/Y, suggesting a non-negligible easing of cost pressures that is also likely in due course to lead to a softening of consumer price inflation too.

All eyes tomorrow will be on the US CPI report for May. Given a further decline in energy prices, Daiwa America economists expect consumer prices to have risen just 0.1%M/M, to leave the annual rate easing 0.9ppt to 4.0%Y/Y, the lowest since March 2021. But core prices are expected to have increased a further 0.4%M/M, reflecting sticky services prices. This would leave core inflation down just 0.3ppt to 5.2%Y/Y. UK labour market numbers are likely to see a slight moderation in employment growth and a rise in the unemployment rate in the three months to April. But with the labour market still tight, we expect wage growth to remain close to the 5.8%3M/Y rate recorded in March, with private sector pay growth in particular still too high for the BoE’s comfort. Final German CPI and ZEW investor survey also due.

UK GDP data for April are likely to report a modest rebound (of about 0.2%M/M) from the drop in output in March (-0.3%M/M), supported by growth in services including retail sales. Euro area industrial production data for April are likely to report a solid increase (circa 1.0%M/M) reflecting not least a surge in Irish output that month. Meanwhile, US PPI figures are expected to show that producer prices fell in May (-0.2%M/M), reflecting further adjustments in wholesale energy markets as well as softer food prices. But when excluding food and energy, core prices are expected to have risen 0.2%M/M.

Japan’s goods trade report for April is expected to report a further modest narrowing in the deficit on the back of another notable drop in the value of imports. But exports are also forecast to have declined compared with a year earlier for the first time since February 2021, in part due to ongoing subdued demand from China. Indeed, Chinese retail sales and industrial production figures are expected to show that activity remains relatively subdued in May. US retail sales and industrial production data are also expected to show that output merely moved broadly sideways in May.

Final May euro area inflation figures are expected to confirm the sizeable drop in the flash headline HICP rate, by 0.9ppt to a fifteen-month low of 6.1%Y/Y. The flash core rate also moderated, by 0.3ppt to a four-month low of 5.3%Y/Y. This will provide a more granular breakdown, along with various measures of underlying price pressures watched by the ECB. Meanwhile, having reached a record high at the end of 2022 (5.7%Y/Y), euro area labour cost growth might well have moderated slightly in Q1, despite a pickup in negotiated wage growth. The BoE’s household inflation attitudes survey and US University of Michigan’s consumer sentiment survey will be watched for the latest developments in medium-term expectations.

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