Why the Fed Should Pause Before Raising Rates Again

I believe the Federal Reserve should hold rates steady when it meets on October 27th and 28th. On September 16th the Fed raised its target range by 25 basis points to 3.75% to 4.00% and I do not think the data we have in hand justifies a second hike this soon. Inflation is still running above the 2% target and parts of the economy are clearly strong. I am not brushing either of those aside. The issue is that hiring has slowed to a crawl and the inflation baseline was just revised lower which makes another increase in borrowing costs look like a bet the Fed does not need to make right now. Unless the next round of reports changes the outlook in a meaningful way I would want much clearer evidence that underlying inflation is accelerating before signing off on another hike. Below I walk through what the August inflation report actually changed, why the September jobs report deserves more weight than it is getting, the strongest argument against my view and the October data calendar that will force the Fed to decide before it sees the full picture.

Inflation came in below forecasts but the monthly pace picked up

The Bureau of Economic Analysis (BEA) released the August Personal Consumption Expenditures (PCE) report on September 30th and the annual readings were softer than economists expected. Headline PCE rose 3.4% YoY which was below the 3.7% the Dow Jones Newswires and Wall Street Journal survey was looking for. Core PCE which excludes food and energy increased 3.0% YoY which also came in under the 3.3% forecast. Those forecasts were the expectations published ahead of the release so they should not be confused with prior actual readings.

Before anyone reads this as inflation suddenly falling in August I want to point out that both annual readings matched July once July was revised. Reuters reported that the BEA updated its historical estimates and that methodology changes helped pull the baseline lower. The surprise came from the revisions rather than from a sharp drop in prices during the month. The monthly numbers actually moved the other way as headline PCE rose 0.3% in August after a revised 0.1% gain in July while core PCE rose 0.2% after 0.1%. Prices are still going up and the monthly pace picked up. My read is that the revised data takes some of the urgency out of another hike while the monthly acceleration is a reason to keep a close eye on things. A better-than-expected print gives policymakers new information but one report is a long way from proving inflation is on a reliable path back to 2%.

It also matters which measure the Fed is aiming at. The Fed’s 2% objective applies to headline PCE over the longer run. Core PCE is useful for gauging underlying pressure but food and energy are still part of every household budget. I do not think the headline number can be waved away just because core looks better.

Hiring deserves more weight than it is getting

The September jobs report was the weakest piece of data in this stretch. Nonfarm payrolls increased by 29,000 which was well short of the 90,000 the Reuters poll of economists expected. The Bureau of Labor Statistics (BLS) report also revised July and August down by a combined 60,000. July now shows a loss of 10,000 jobs and August shows a gain of 133,000. When I average July through September I get roughly 51,000 jobs per month. One weak month can be noise and I would never hang a policy call on a single print. A soft month that arrives with downward revisions and a three-month average near 51,000 is a different situation and I think the headline needs to be read together with the revisions and the trend.

Unemployment ticked up to 4.2% from 4.1% while labor force participation rose to 61.8% from 61.6%. Part of the rise in the unemployment rate came from more people entering the workforce which is a much better reason for it to move higher than layoffs. Average hourly earnings grew 0.1% for the month and 3.0% YoY. Wages growing 3.0% while headline PCE is running at 3.4% does not look like a wage-price spiral to me. The BLS described employment and unemployment as little changed and I agree that this report does not point to a recession or a wave of layoffs. What it does is make it much harder to argue that the labor market needs more restraint right now. I see it as a reason to be careful about putting more pressure on hiring.

Strong domestic demand is the best argument against a pause

The strongest pushback against my view comes from spending and investment. The BEA revised second-quarter real GDP growth up to a 2.2% annualized rate from 1.5% in its third estimate. The number that jumped out to me was real final sales to private domestic purchasers which grew at a 4.6% annualized rate. That measure combines consumer spending and private fixed investment and leaves out inventories, government spending and trade so it gives a cleaner look at private demand. Keep in mind that annualized rates show quarterly growth as if that pace held for a full year. They are not the actual percentage increase inside the quarter. Even with that caveat there is real strength underneath the GDP headline.

August added to that picture as inflation-adjusted consumer spending rose 0.6% for the month while inflation-adjusted disposable income was flat and the personal saving rate sat at 4.1%. Consumers are still spending but in August they spent faster than their real incomes grew. This is the main reason I am arguing for a hold rather than a cut. Demand is strong enough to keep inflation risk on the table. At the same time one strong quarter of spending does not automatically mean the next quarter needs another hike. Resilient demand alongside modest hiring is a mix that calls for weighing both risks carefully and I do not see it as a case for moving again in October.

The September hike has not had time to work

There is a timing issue in the jobs report that I think is getting overlooked. The payroll survey measures employment for pay periods that include the 12th of the month. The Fed hiked on September 16th so the September report cannot be a clean test of what that increase did to hiring. Blaming the hike for the weak payroll number would be premature. The Fed itself explains that monetary policy works through financial conditions including the cost and availability of credit and that its effects on jobs and inflation are neither direct nor immediate. Policymakers have to think about how decisions made today affect the economy later and that is where my concern sits.

Borrowers can see their financing terms change well before any clear effect shows up in aggregate hiring or inflation. If the Fed keeps raising rates while it waits for confirmation it runs the risk of doing more than it needs to. Waiting carries its own risk if inflation becomes more persistent and I am not pretending otherwise. I favor a pause because the recent data make the tradeoff less favorable for another immediate increase. One meeting will not reveal the full effect of the September hike. It will give the Fed another month of data on which direction the economy is heading.

Borrowing costs would hit households and businesses unevenly

A higher policy rate can raise financing costs for households and businesses but how much depends on the loan and whether its rate adjusts. As a rough example a 25-basis-point hike that passed through fully to a variable-rate loan with a constant $10,000 balance would add about $25 in annual interest. On $1 million of business debt that reprices the same way the increase would be about $2,500 a year. These are simple interest calculations before repayments, fees or compounding and they are not a forecast for any specific borrower.

An existing fixed-rate mortgage would not get more expensive. New mortgage rates follow longer-term market yields and lending spreads so they do not move mechanically with every Fed decision. Earlier I wrote an article on why mortgage rates do not move in lockstep with the Fed (can be read here) where I go through that distinction in more detail. A single 25-basis-point move is not going to decide where the economy goes. Additional tightening still has a cost and I think policymakers need a convincing reason to impose it when hiring is already this soft.

Our own forecast is a reason to keep watching inflation

Our own tracking at Nowflation pushes back on the pause argument in a useful way. As of October 4th the Nowflation forecast for September headline Consumer Price Index (CPI) inflation was 3.60% YoY which is above the latest official August CPI reading of 3.4% shown on the current inflation dashboard. This is a forecast for a different index and a different month than the August PCE report. It should not be treated as an official result or compared directly with core PCE. It does reinforce why I am not declaring victory over inflation. Headline pressure could build even while some underlying measures look better. The next release needs to be broken down by component and tracked over several months to tell whether price increases are becoming more persistent and widespread.

One thing I always want readers to keep straight is that Nowflation’s live measures, the CPI Gauge and the forecast each answer a different question. Check the labels and dates rather than grabbing whichever number best supports the Fed call you already prefer. The current CPI forecast can still change until it locks ahead of the release and only two live calls had been graded as of October 4th according to our methodology and track record and the forecast process. I also wrote an article explaining why CPI and PCE give different inflation readings (can be read here) if you want more background on why the two gauges disagree.

The October calendar makes this a harder call

The order of the next reports matters. The Fed will have September CPI in hand before it decides but the next PCE report and the next national jobs report land after the meeting. Based on the BLS October calendar, the Federal Reserve calendar, the BEA release schedule and the BLS notice for the next employment report the sequence looks like this as of October 4th.

The October decision will be made with incomplete information. CPI, producer prices and weekly jobless claims will help but they cannot stand in for every report that arrives after the meeting. I would rethink a pause if underlying inflation picked up persistently across many categories, if longer-term inflation expectations rose meaningfully or if demand clearly started running ahead of the economy’s capacity. Any of those would strengthen the case for another hike. A single monthly surprise in either direction would need context before I changed my view.

Based on what we know today I would keep the federal funds target at 3.75% to 4.00% in October and stay open to changing course as the outlook develops. Getting back to price stability matters for every household dealing with higher living costs. Keeping people employed matters for those same households. The Fed already moved in September and I want to see stronger evidence that another increase is needed before it moves again. I will be tracking every release on Nowflation Fed Watch and the CPI forecast page as the reports come in.