As was universally expected the Fed left the policy rate target unchanged at 5.25-5.5 per cent this week.

In so doing the Fed acknowledged that inflation had been a little “stickier” than they had anticipated noting that in “recent months, there has been a lack of further progress toward the committee’s 2% inflation objective”.

However, Fed Chair Powell nevertheless insisted that progress has been made on inflation and that expects further progress with the maintenance of current stance of policy even if a return to the 2 per cent target may take longer than previously anticipated.

Acknowledges “stickier” inflation but sees “normalising” labour market

While acknowledging the “stickiness” of inflation, the Fed Statement and the tone of Chairman Powell’s press conference were probably less “hawkish” than markets had feared. The Fed noted that the risks to achieving the Fed’s employment and inflation goals “have moved toward better balance over the past year”. The previous statement said the goals were “moving into better balance.”

In his press conference, the Fed Chair instanced signs of a softer labour market. He may have had in mind the March JOLTs report showing US job openings fell in March to the lowest level in three years while quits and hiring also slowed, indicating more softening in the labour market.

The less hawkish tone than feared saw equity markets rally strongly, bond yields decline, and a weaker USD following the Fed announcement.

Policy still restrictive as “last mile” challenges remain but retains “easing” bias

Fed Chair Powell continues to describe policy as “restrictive”. In that context, the message seems to be that recent inflation developments delay the first reduction in the policy rate rather than lead the Fed contemplate a further increase. Indeed, Fed Chair Powell described the latter as “unlikely”.

Inflation indications since the Fed last met are a reminder that the process of disinflation tends to be more disjointed: a process of “two steps forward and one step back” with the “last mile” to the inflation target proving particularly challenging, particularly in an environment (such as in the US) where economic activity has been resilient.

There are other key structural elements at work that will make that “last mile” even more daunting. The globalisation of labour supply (after the fall of the Berlin Wall and the “export” of labour from large emerging market economies such as China and India) is abating.

The first quarter Employment Cost Index (ECI) released on Wednesday showed higher than anticipated wage growth which underscores the inflation challenge.

The Fed’s job has not been made easier by fiscal policy. That the US is running a budget deficit of over 6 per cent of GDP at a time of full employment is a key reason behind the “stickiness” of inflation. That the budget deficit reflects measures associated with President Biden’s Inflation Reduction Act is a supreme irony.

The US regulatory complex is also complicating the Fed’s task. The bipartisan endorsement of a resort to protectionist measures through subsidies and / or tariffs under the guise of “industrial policy” and “national champions” or “supply chain security” will add to “last mile” challenges. These measures make it structurally more difficult to get inflation down, as does a proclivity to greater regulatory oversight of goods and labour markets.

Markets pricing one 25 basis point cut

Getting back to the Fed, markets are now pricing a little over one 25 basis point reduction in the policy rate.

Given the measured tone of the Fed Statement and the less hawkish disposition presented by the Fed Chair’s press conference that seems a reasonable expectation.

Coming up: US April non-farm payrolls

Fed Chair Powell has characterised the labour market as “normalising”.

As important as the payrolls data are, in the absence of a report a long way from expectations, it will be progress on inflation that will determine whether the Fed chooses to enact any policy rate cuts.

In this context, markets will likely be particularly exercised regarding the extent to which the April report reveals some tempering of wage pressure as well as focussing on conventional measures of employment growth and the unemployment rate. Decelerating wage growth would encourage a more positive narrative on inflation abatement and a more positive backdrop for financial markets and vice versa.

The consensus estimates for April non-farm payrolls are for an increase in employment of around 240k, an unchanged unemployment rate at 3.8 per cent, and for average hourly earnings to slow to 4.0 per cent annual growth from 4.1 per cent in March.

The March Job Openings and Labour Turnover Survey (JOLTS) report released on Wednesday indicated some degree of softening in the US labour market.  

The employment component of the Institute for Supply Management (ISM) April Purchasing Managers Index (PMI) for manufacturing released on Wednesday is also consistent with a softening labour market.

The ADP payrolls report released overnight Wednesday showed employment growing 192k (versus an expected 180k). While a reasonable enough indicator in and of itself, its record in foreshadowing month-to-month movements in the Bureau of Labor Statistics payrolls measure is at best mixed.

An outcome close to expectations for the aforementioned components of the non-farm payrolls report won’t move the dial for the Fed to where markets reside.  

The real test comes next week with the release of the April US CPI on Wednesday 15 May.

Stephen Miller is an Investment Strategist with GSFM. The views expressed are his own and do not consider the circumstances of any investor.