Policy Pause Coming?

With the debt ceiling crisis possibly close to resolution, the stock market may turn cautious as it focuses on the likelihood of a pause in Fed tightening at the June 13-14 FOMC Meeting.  Fed officials made somewhat conflicting comments regarding a pause last week.  Some Fed Bank Presidents said that recent US economic data were not weak enough to justify a pause.  In contrast, Fed Chair Powell said that rates may not have to be lifted as much as the markets anticipated because of tighter credit conditions stemming from the banking crisis. The decision at the June FOMC Meeting may depend on /1/ upcoming evidence of weak economic activity or low underlying inflation, or /2/ evidence of a sharp tightening in bank lending.

The Fed Presidents are right that the latest data have not been weak.  The most important data last week were the declines in Initial and Continuing Unemployment Benefits Claims.  They reversed the prior week's jumps and brought them back to levels in line with those seen since March.  They do not show a significant worsening labor market in May.  The 4-week average of Initial is 244k, not much different from the 240k going into the April Payroll Survey Week.  Continuing are below the level in the April Survey Week.  We need one more week of Continuing Claims data to complete the picture of the labor market moving into the May Employment Survey Week.  As they stand now, the data raise the risk of another speedup in May Payrolls.

Although a worsening labor market hurts many people, it may be necessary to bring down wage inflation.  What's putting upward pressure on wage inflation may be a too-high level of economic activity.  The level has to fall.  There are two ways to lower the level of activity relative to long-run trend: /1/ recession or /2/ an extended period of below-trend economic growth.  The latter takes time (perhaps more than the typical year-long length of recession).  And, the downside is that high inflation could become entrenched during this period.  Moreover, slow growth would be as painful as recession for some people.  So, the Fed may decide that further aggressive policy tightening with a consequential recession is preferable to a pause in tightening.

One development that could change this decision is a sharp slowdown in price inflation.   The flattening in commodity prices is helpful, but they represent a small share of production costs.  A sharp slowdown in housing rent could help significantly.  Ironically, Fed tightening could be working against   this possibility.  Higher interest rates reduce demand for home ownership, pushing more people into the rental market.  They also make it costlier for builders to construct new homes, thus limiting supply.  Housing Starts have been in the 1.4-1.5 Mn range (annualized), which is below the estimated 1.62 Mn pace needed to meet annual demand.