Fed wants to 'take a breather' and assess rate hike impact on economy: Economist

May's CPI report showed that inflation is slowing, but it's still not where the Fed wants it to be. RSM Chief Economist Joe Brusuelas breaks down the market outlook and details why services inflation is an area to watch.

Video Transcript

RACHELLE AKUFFO: Well, we're looking ahead to the Federal Reserve's rate decision at 2:00 PM Eastern. And as of this morning, most people are looking for a pause in rate hikes, especially after yesterday's inflation print showed that prices are easing considerably in some sectors.

Joining us now is Joe Brusuelas, RSM chief economist. Joe, good to see you here. Now, we know that one data point that you highlighted in a tweet yesterday is services inflation slowing to a 2.9% three-month average annualized pace. So why does this stand out to you? And how might it impact the Fed?

JOE BRUSUELAS: --are watching, of course, services like shelter and the three-month average pace has slipped 2.9%. Broader services is around 2.6% over that same time. And that puts the Fed in a position where they can hold at least for another month before they have to consider hiking.

When you think about the financial tightening caused by the turmoil among local and regional banks, and you think about this tsunami of issuance the Treasury is having to do following the debt ceiling crisis, that equals about 75 basis points of stealth tightening. So I think the Fed really wants to just take a breather and assess just how the past impact of policy is now impacting the real economy. And I think that's the key here.

Now, you guys had a great data vis up there earlier with the dot plot. Only three of them have to move up to that area to push the dot plot up so that the median's somewhere between 5.35% and 5.6%. And I think that's going to be the real narrative that emerges from at least the publication of the statement. And then we'll take a look at what goes on in the summary of economic projections.

RACHELLE AKUFFO: And I mean, when you look at what some of the other central banks are doing, still continuing to raise, although they did start at a later time than the US Fed did. Where are we now then? Because that one CPI print, it took the Fed watch tool from a 75% chance of a pause to 95% here. So is it essentially a done deal? Is there any chance at all that we could actually see a hike.

JOE BRUSUELAS: Well, of course, there is. All of these meetings right now should be considered live. Now, I don't think that's the case. We're going to get a hike with a tightening bias. Clearly, when you see the vise chair of the FOMC signal to the markets two weeks ahead of a meeting, it's pretty clear what the Fed's going to do.

Now, one thing, and you asked a really good question about the global central banks and the global economy, the US is a little bit out in front of most of the other central banks, meaning that inflation's actually moving in the right direction. And it's actually falling at an accelerating rate, even if the service sector inflation, defined broadly, you still see some stickiness there.

In Canada, things just were growing at too quick of a rate. And obviously, in Australia as China opens up and they're exporting commodities, the Reserve Bank of Australia did impose a surprise rate hike. But I just don't see that today.

RACHELLE AKUFFO: Now, I want to ask you about this 2% inflation target. Do you think the Fed perhaps needs to revise its playbook a bit? I mean, when you look at the significant changes on the supply side of the economy, and when you look at some of the imbalances that we see in the labor market as well.

JOE BRUSUELAS: Sure, the shocks to the economy following the pandemic, the de-risking away from China amongst the US and its G-7 trade partners, and of course, the long-run demographic issues around the US labor market all point towards a period of inflation that's not going to look like the past 20 years.

That will require higher interest rates and I think a new inflation target on the other side of this, which I think should be set right around 3%. Now, the Fed's not going to do that right up into the fact that they tell you that they've changed it, right? But we'll see today perhaps the medium term view on inflation may actually be pushed up a bit.

And you'll begin I think to see lots of talk going forward this year and next around the appropriateness of a 2% target and the collateral damage that the Fed would have to cause in the labor market in order to get there. I just don't think there's an appetite for it in the country, and especially in Washington.

RACHELLE AKUFFO: So then as we enter this phase of a Fed pause, whether it ends up being a skip or in fact a pause in a pivot, I mean, you see top line inflation and drivers of core pricing likely to ease notably in the coming months. What sort of numbers could we be talking, and which sectors will be the standouts?

JOE BRUSUELAS: OK. So the year-over-year base effects in energy and commodities clearly are what's going to drive the June numbers that we'll get in July. You're going to see the top line CPI be much closer to 3% than you are 4%. And then we're going to begin to see in months after that, it's going to be all about rents, the owners' equivalent rent in particular and the cost of shelter.

It's very clear that real-time data shows that rents have actually rolled over because the way the Fed estimates it inside CPI. You won't tend to see that in real-time. You get about a six month lag. So we would always pin the second half of the year, really the end of the third quarter and to early fourth quarter when rents would roll over. And that's going to provide substantial relief in terms of top line inflation and also core inflation inside the CPI.

Now, the Fed looks at all of this, of course. But what they're really focused on is the PCE and core PCE. And that's where rents have a little bit of a less weight than they do on the CPI. Therefore, it's going to slow not as quickly as you'll observe and what the public looks at, which is the CPI index.

RACHELLE AKUFFO: And for people who are wondering in terms of a soft landing, a hard landing when you still have consumer spending the way that they are, how do you see things playing out?

JOE BRUSUELAS: OK. As long as we're producing north of 200,000 jobs a month, as long as households are spending somewhere between the 2% and 3% clip, it's hard to make the argument that we're going to fall into recession. Now, because of the past impact of Fed rate hikes, the financial tightening that we've talked about, we've assigned a 75% probability of a recession over the next 12 months.

But let's talk about what that means. It means there's a 25% probability that we get a soft landing, and that's non-trivial. So if you run the model four times in one day, one of the times, you're not going to have that hard landing and you are going to get the soft landing. And to be honest with you, the way the data has been evolving, we may need to pull that estimate back in our mid-year economic review, which will publish in early July following the June non-farm employment report.

RACHELLE AKUFFO: I'm sure we'll have you back to break all of that down for us. A big thank you there to Joe Brusuelas, RSM chief economist. Thank you for joining us.

JOE BRUSUELAS: Thank you.