A Fed Rate Skip, What's Next?

The stock market may view this week's FOMC outcome as a non-event if the Fed decides to skip a rate hike.  The market focus should continue to be aimed at Iran war developments and the mid-term elections.  

Two major macro questions regarding the post-election situation are /1/ whether the Iran war will expand or be resolved and /2/ whether and by how much will the Fed tighten ahead.   Reports of US-Israeli plans for a short strike is a negative for the market outlook.  However, reports of continuing US-Iranian negotiations keep open the possibility of a peaceful resolution.  As for future Fed policy moves, a significant slowdown in inflation is likely needed to prevent the Fed from tightening.  Otherwise, at least one more rate hike is the risk, given that Fed Chair Warsh has said that even steady above-target inflation is unacceptable. 

As for this week's FOMC Meeting, the Fed can justify a pause in tightening by arguing the recent price shocks -- oil, tariffs -- are largely beyond their control.  With little if any inflationary pressure coming from the labor market, it can wait to see how the fall-out from the shocks evolve.  Weakening the labor market, which further tightening would lead to, may not be needed to lower inflation over time if the shocks begin to unwind.  The strong dollar meanwhile is working to hold down inflation already.  These arguments could allow them to avoid  the politically-problematic choice of hiking rates in front of the mid-term elections.

A problematic labor market also could help persuade the Fed to hold off on hiking at this meeting.  Although layoffs are down, seen in the decline in Initial Unemployment Claims, hiring may have slowed as well, seen in the increase in Continuing Claims.  So far in October, Initial Claims are below their September average while Continuing are above theirs.   At this point, the data suggest another sluggish Payroll increase in October.  The slowdown in wage inflation, reflected in Average Hourly Earnings in Q326 and the broader Compensation/Hour in H126, may attest to the pullback in labor demand by companies.

Strong Productivity Growth may be substituting for job growth, possibly AI-related.  If this week's release of the first report on Q326 Real GDP Growth is close to the 3.0% consensus estimate (Atlanta Fed model's estimate is 3.5%), Nonfarm Productivity Growth should be better than the 1.1% pace in H126 and possibly in line with the strong 2+% trend seen since 2024.  Unit Labor Costs could come in below 2.0%, as in H126, and remain consistent with 2% price inflation -- attesting to the Fed's view that inflationary pressures are not emanating from the labor market.  To be sure, the costs of using AI offset some of the labor cost savings.

The consensus estimate of the September PCE Deflator is similar to the high CPI for the month.  Consensus looks for +0.5% m/m Total and +0.3% Core PCE Deflator.  The y/y for Core is seen edging up to 3.1% from 3.0%.  However, like the CPI, much of the Core's increase can be traced to the oil/tariff price shocks and AI-related shortages of computer parts.  So, this Report is not likely to change Fed views of the inflation outlook.  The hawks will see reason to hike while the Doves will hold to the hope that effects of the shocks wear off by next year.  Note that Fed Chair Warsh could announce the Fed staff's estimate of the September PCE at the post-FOMC news conference, as has been the practice.  The PCE Deflator will be released the next day.