US - ‘Tis the season to be easin’

The Fed’s hotly anticipated easing cycle started off strong with a 50bps cut in September. In the three months preceding the decision, headline CPI inflation ran at 1.1% annualized, while core CPI was 2.1%. PCE inflation came in at 1.5 and 2.1%, respectively. Jobs growth had been weak, averaging 140k per month in the three months prior, compared to 267k in the first quarter of the year. The unemployment rate averaged 4.2%, well above the 3.8% in Q1. Further motivated by a pessimistic Beige Book, the Fed judged the downside risks to employment and upside risks to inflation to be sufficiently balanced to take a big step towards neutral by immediately cutting rates by 50bps. Since then, September labor market figures exceeded all expectations, coming in at 254k versus 150k consensus, pushing the unemployment rate back down to 4.1%. Similarly, the September CPI readings came in hotter than expected, with the monthly change in headline coming in at 2.2% annualized, while the core figure even reached 3.8% annualized. Was the Fed too soon in easing off the brake?

The chart on the left above shows a decomposition of CPI inflation into its major categories. Fed Chair Powell has said that his confidence in inflation coming down hinges on a broad-based decline across all core categories: goods, housing- and non-housing services. He contrasted the Q2 inflation figures with the low inflation period in Q4 2023, which was mainly driven by goods deflation, while both categories of services inflation were still elevated. Non-housing services came back with a vengeance last month, with some notable, and seasonal outliers, such as college textbooks, admission for sporting events and airfares – components strongly associated with the return to work and school after the end of summer. The estimation of seasonal effects, which are strong in September, has become much harder since the pandemic. Last year, September also saw a similarly strong seasonally adjusted increase in non-housing services prices. Meanwhile, housing services inflation actually eased to pre-pandemic levels. Pressure is expected to remain subdued, as the shelter CPI has now effectively caught up to price changes in third-party data, such as the Zillow observed rent index.

We see a similar story for non-farm payrolls in the chart on the right. Between June and August, a combination of new releases and downward revisions of the previous months, showed a sudden decline in job creation. September then gained 254k jobs, the third highest reading of the year. The sector decomposition shows large contributions from two highly seasonal sectors: leisure and hospitality, and education. Leisure and hospitality hiring was not driven by an actual creation of jobs, but rather just a smaller decline than is usual in September. Hiring in education was stronger this year than in previous years. Here, too, last year’s September data release mirrors this year’s. In September 2023, non-farm payroll gains came in at 336k, versus 170k consensus. The figure was ultimately revised down to 246k a month later.

In short, while these headline figures in the first instance seem to reflect poorly on the choice to cut rates by 50bps, leading markets even to price a small chance of a pause in the easing cycle, a more careful assessment leads to a less hawkish interpretation of the data. It remains important to look through the short-term variability. The upcoming labor market report is likely to be a lot weaker, but should also be read in the context of the hurricanes that hit the economy in October. Inflation is likely to moderate and remain on course to reach 2%. At the same time, Q3 growth is likely to come in strong, with the Atlanta Fed tracker putting it at 3.4% annualised. The incoming data is therefore expected to remain consistent with a soft landing scenario, and we expect the Fed to gradually reduce the policy rate with 25bps in each upcoming meeting.