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May 2023 / VIDEO

Stubborn Services Inflation Keeps Fed on Guard

Key Insights

  • U.S. economic growth in the first quarter slowed notably from late 2022, but this was mainly driven by inventory declines.
  • The labor market also appears quite resilient, though layoffs have spread beyond the tech sector.
  • We’ll need to see more evidence of a deceleration in services inflation to have confidence in overall inflation returning to 2%.

Transcript

In the first quarter of this year, U.S. economic growth slowed significantly from late 2022, but this was mainly driven by inventory data. Excluding the effects of inventories and net trade, which tend to be volatile quarter to quarter, growth in domestic demand was strong.

Consumer spending on goods was a silver lining in the first quarter. It was particularly evident in auto sales. However, given rising interest rates and higher average selling prices for cars in recent years, I expect that demand for cars will slow going forward.

The labor market also appears remarkably resilient. But I am looking at survey data as a leading indicator of what lies ahead. In these surveys, private sector hiring intentions are coming down, particularly from small businesses. Layoffs also spread beyond the tech sector, although they are not at recessionary levels at this point.

As demand for workers slows, I expect that job vacancies and postings will drop further, leading to a cooling in wage pressures later this year or in early 2024. Overall, though, I do not see any major cracks in the labor market, and I only expect a small uptick in the historically low unemployment rate by the end of 2023.

Turning to inflation, overall measures of consumer prices have fallen quickly along with energy. However, we have seen less improvement in core inflation rates, which exclude the volatile components of food and energy.

Recent data has shown some signs of deceleration in rent inflation, and we care about this because it is a major component of services prices. But we’ll need to see further evidence of a broader deceleration in inflation and prices to have confidence that overall inflation will return to 2%.

That brings us to the Fed. Its inflation target is, of course, 2%. And markets right now are pricing multiple Fed cuts in the second half of the year. But I think that the inflationary environment is such that the Fed will not be in a position to cut interest rates anytime soon. When I look back at 2022, I think of it as the year when the market kept pricing a Fed pause too soon. 2023 so far feels like the year the market is pricing Fed cuts too soon.

When the Fed does eventually move to loosen monetary policy, I think that the elevated inflation risk in the background will prevent it from cutting rates as quickly as it has in past economic cycles.

Looking at the broader picture, the central bank is clearly now fully data dependent. What I mean by this is that policymakers are monitoring indicators other than inflation, such as credit conditions, to look for signs of growth slowing.

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