June FOMC Preview: So You're Telling Me There's a Chance?

Summary: The June decision is likely to come down to the wire, but we maintain our long-held view that the Fed will tighten rates by a final 25bp in June to a range of 5.25%-5.50%. If the Fed decides to 'skip' the June meeting, we expect the decision to be accompanied by communication that leans hawkish, signaling a likely hike for July.

“I do not expect the data coming in over the next couple of months will make it clear that we have reached the terminal rate. And I do not support stopping rate hikes unless we get clear evidence that inflation is moving down towards our 2 percent objective. But whether we should hike or skip at the June meeting will depend on how the data come in over the next three weeks.”

That was an excerpt from Governor Waller's comments on May 24 where he described the Fed's current dilemma regarding the June FOMC decision. The speech was aptly titled 'Hike, Skip, or Pause?' and the data after his remarks continued to come in stronger than expected:

• Core PCE inflation was revised higher for Q1, while the core PCE deflator for April surprised expectations to the upside, posting a still brisk 0.4% m/m increase. More importantly, underlying inflation gauges continued to show no clear signs of slowing down.
• Nonfarm payrolls easily exceeded expectations for a second consecutive report in May (339k), with the series posting its largest gain since January. If the rebalancing of the labor market is a prerequisite for the convergence of services inflation to more normal levels, the Fed will be hard-pressed to find significant progress in the May payrolls report.
• CPI inflation in the May report on June 13th will certainly be a factor as well. We remain of the view that the core segment will continue to expand at a fairly strong pace.

In a nutshell, key macro data published since Governor Waller made his remarks solidify the view that the Fed should not be claiming the end of its tightening drive. Underlying inflation has failed to show convincing signs of slowing, and the labor market remains exceedingly strong despite the rapid accumulation of rate hikes (500bp worth). If Fed policy were truly data dependent the case for a rate increase at the June meeting would be an easy one to make, in our view.

However, banking-sector stress stemming from the recent banking crisis has clouded the economic outlook. Indeed, the May FOMC meeting minutes noted that “almost all participants commented that downside risks to growth and upside risks to unemployment had increased because of the possibility that banking-sector developments could lead to further tightening of credit conditions and weigh on economic activity.” Data so far points to a reduction in credit creation, mostly stemming from small banks and particularly in C&I lending.

However, we don't know if credit was already meant to contract at this rate as a result of the Fed's rapid tightening of policy and regardless of banking-sector stress. Nor how much of the current contraction in credit is due to increased risk-aversion after the SVB collapse. While the drivers are hard to disentangle, surveys suggest that recent gyrations in the banking sector have not played a major role; at least not yet.

Whatever the final impact, Fed officials appear to be assuming that risk-aversion and lower credit supply post-SVB collapse is likely to amount to about 25-50bp worth of rate increases, and so far the impact seems to be evolving in an orderly manner. The more extreme tail risk scenarios have also been largely ruled out for now. In effect, the market agrees that the policy easing that was penciled in during peak recession-fears post-SVB failure (with cuts priced-in as early as in July) has been almost fully priced out for 2023.

The Case for 'Skipping' in June

However, uncertainty about the outlook remains, with two-way risks for growth now more balanced. A number of Fed officials judges that the rapid accumulation of rate hikes and the now-restrictive policy stance afford them to be more patient when formulating the next policy steps. That is, buy some time in order to gather and assess additional data.

If the FOMC decides to skip the June meeting it will then need to strongly communicate that it's leaning toward a July hike as that would be the only scenario under which hawkish Fed officials would be supportive of a June pause (Chair Powell prefers to be a consensus builder). The onus would then be on the data published between the June and July FOMC meetings to prove that additional rate increases are no longer needed.

If that is the case, Fed communication could become even more problematic, and the market's understanding of its reaction function could become murkier. Note that the FOMC smartly decided to drop the last vestiges of forward guidance in May as uncertainties rose, and risks became more balanced. However, at the same time it further elevated data-dependency as the key guide for its reaction function. If the Fed skips June and signals a hike for July, it would be regressing to a form of forward guidance.

Avoid the 'Skip'

Needless to say, the June decision will be a very close one, but we are maintaining our long-held view that the Fed will tighten rates by a final 25bp in June to a range of 5.25%-5.50% and continue to expect it to keep the door open to additional policy tightening if necessary. We also believe that markets are underpricing the probability of a rate increase in June (à la Bank of Canada). In our view, if the hard data points to an economy that remains strong enough to make the Fed signal a likely rate hike for July, it is more optimal to go now.

If on the other hand the Fed decides to skip the June meeting, we expect the decision to be accompanied by communication that leans hawkish (i.e., dot plot, economic projections, and the Chair's post-meeting presser). In other words, a 'hawkish skip'.