Fed Pauses Rate Hikes as Inflation Pressures Cool and Economic Growth is Sluggish

Key Takeaways:

• The Federal Open Market Committee (FOMC) held the federal funds rate steady at a target range of 5-5.25 percent at its June 13-14 meeting, ending a streak of 10 consecutive rate hikes. In addition, the committee released an updated Summary of Economic Projections (SEP), which projects the terminal federal funds rate in 2023 to be 5.6 percent, 50 basis points above its current level. The committee also revised upward its 2023 median estimate for Gross Domestic Product (GDP) growth from 0.4 percent to 1.0 percent.
• The Consumer Price Index (CPI) rose 0.1 percent in May, according to the Bureau of Labor Statistics (BLS). On an annual basis, prices rose 4.0 percent, a sharp deceleration from the 4.9 percent annual rate in April. Energy prices fell 3.6 percent over the month as gasoline prices declined 5.6 percent and energy services declined 1.4 percent. Core prices were a bit hotter, rising 0.4 percent over the month for the third consecutive month, bringing the annual rate to 5.3 percent, a deceleration of two-tenths from April. Prices for used cars and trucks jumped 4.4 percent for a second straight month. Shelter was also strong, rising 0.6 percent over the month and 8.0 percent over the year.
• The Producer Price Index (PPI) declined 0.3 percent in May, according to the BLS. The year-over-year rate fell 1.2 percentage points to 1.1 percent, the lowest since December 2020. Core PPI was flat over the month as final demand for goods prices dropped 1.6 percent while final demand for services prices were up a modest 0.2 percent. Over the year, core PPI slowed five-tenths to 2.8 percent.
• Retail sales and food services increased 0.3 percent in May, according to the Census Bureau. Part of the strength was due to a 1.4 percent gain in spending at motor vehicle and parts dealers; excluding these sales, retail sales were up only 0.1 percent. Sales at building materials and garden equipment stores were also strong, rising 2.2 percent. Restaurant and bar sales were up 0.4 percent. Core retail sales, which exclude food services, autos, building supplies, and gas stations, increased 0.2 percent.
• Industrial production, a gauge of output in the manufacturing, utility, and mining sectors, was down 0.2 percent in May, according to the Federal Reserve Board. The decline was driven in part by a 1.8 percent fall in utilities output, which is often dependent on the weather. Mining output declined 0.3 percent while manufacturing output was up just 0.1 percent.
• The National Federation of Independent Business (NFIB) Small Business Optimism Index increased 0.4 points to 89.4 in May. There was a 6-point jump in the number of firms planning capital expenditures, which rose to 25 percent on net, though the net percentage of firms expecting the economy to improve, expecting real sales to be higher, and expecting credit conditions to ease all declined. The percent of firms raising average selling prices declined 1 point to a net 32 percent, though a net 29 percent of firms plan to raise average prices in the next three to six months, an increase of 8 percentage points. At 25 percent, inflation was rated as the single most important problem facing a plurality of businesses, though that’s still down from a peak of 37 percent in July 2022.

Forecast Impact:

Headline inflation cooled significantly in May, in line with our expectations. We expect a continued cooling in inflationary measures through the year, due in part to more favorable base effects – inflation was hot and broad-based last summer whereas most pressures have since eased, aiding the year-over-year comparison. In addition, producer prices were again soft, indicating that lower input prices may soon feed through to consumer prices. While core inflation remained high, this is being supported in large part by shelter costs, which are also expected to cool in coming months given more timely data on new rents and home prices showing near-zero growth, and continued unusual dynamics in the used car market, which we expect will reverse soon based on falling wholesale prices.

The Fed chose not to hike rates for the first time since March 2022 to further assess incoming data and its implications for future policy. Still, the updated SEP suggests two more 25-basis-point hikes are likely this year. While we anticipate a higher-for-longer policy stance from the Fed, our economic outlook is much weaker than the Fed’s and, as a result, our inflation expectations are lower. Therefore, we believe there’s some downside risk to the Fed’s median rate projections if a recession begins in the second half of 2023 as we are forecasting.

This week’s economic data is largely consistent with an economy that is growing at a rate that is below trend. Core retail sales were sluggish, manufacturing output is at about the same level it was six months ago, and business optimism is poor. We believe this is consistent with an economy near its “stall speed,” indicating that a relatively small shock would be likely to push the economy into a recession.

Nathaniel Drake
Economic and Strategic Research Group
June 15, 2023

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