The Fed wants to pause without looking soft

Headline inflation has slowed to 4.0 per cent year-on-year, which gives the Federal Reserve a reasonable case for pausing its rate increases at the June meeting. Central banking relies heavily on choreography, and this decision needs careful footwork. The committee does not want financial conditions to loosen too soon. Its answer is the 'hawkish skip': hold the rate steady while threatening further increases.

Good headline, stubborn core

The May consumer price figures, released on the first day of the Fed's two-day meeting, showed the lowest annual headline rate since March 2021, down from a peak of 9.1 per cent last June. Most of the improvement came from energy, whose prices have fallen back from the highs reached after Russia invaded Ukraine. Core inflation, which strips out food and energy, was still 5.3 per cent over the year and rose by 0.4 per cent in the month, an annualised pace more than twice the Fed's target. Shelter was again the largest contributor. The part of inflation falling fastest is the part that interest rates influence least.

Ten increases and a question

The Fed has raised its target range at ten consecutive meetings since March 2022, taking it from near zero to 5-5.25 per cent, the fastest tightening since the early 1980s. Officials argue that the full effect has yet to reach the economy, and the bank failures this spring have tightened credit further as lenders pull back. That is the honest case for a pause: rates work with long and variable lags, and the committee has not yet seen the results of what it has already done. The difficulty is that saying so plainly would invite markets to price the end of the cycle.

Officials have spent the past fortnight preparing the ground. Philip Jefferson, the governor nominated last month as vice-chair, and Patrick Harker of the Philadelphia Fed both spoke in favour of holding rates at this meeting, and markets duly moved to price a pause. In March the median official projected a peak of 5.1 per cent, which would make May's increase the last. The new projections are the committee's main tool for keeping a pause from being read as that peak.

Why markets won't believe it

Markets seldom believe central bankers who say they will start raising rates again after a break they chose to take. Once a tightening cycle has stopped, restarting it requires data that surprise badly to the upside. By trying to look determined while doing nothing, the FOMC may simply look tired.

The Fed's own history supports the scepticism. In June 2006 it raised its target to 5.25 per cent and then held, while officials insisted for months that the risks still pointed to higher inflation. No further increase came, and the next move, in September 2007, was a cut. A pause presented as temporary has a habit of becoming the peak, because the bar for moving again rises with every meeting at which nothing happens.

The recent record elsewhere complicates that argument. The Bank of Canada declared a conditional pause in January and resumed raising rates last week, after consumer demand and the housing market proved stronger than it expected. The Reserve Bank of Australia paused in April and then raised rates in both May and June. Both restarts, though, followed exactly the kind of upside surprise the Fed would need, and both came from central banks whose rates were lower than America's when they paused. A threat to resume is credible only if officials show they will let the data force their hand, and markets will judge that by what the committee does in July.

Who gains from a skip

A pause helps those who borrow short and hurts those who hoped to earn more on cash. Holders of adjustable-rate debt, from small businesses on bank credit lines to companies with floating-rate loans, get a month without a higher bill. Regional banks, still losing deposits to money market funds, gain some breathing room if short-term yields stop climbing. Savers in money funds give up a little future income. The dollar is the other likely loser, since a Fed that stops while the European Central Bank is still raising rates narrows the gap that has supported the currency.

What would force a restart

The next meeting, on 25-26 July, is the first chance to act, and two releases will decide it. The June consumer price report, due in mid-July, will show whether core inflation is still running near 0.4 per cent a month, and the June payroll report will show whether hiring has kept its pace. Financial conditions matter as well. The S&P 500 has already entered a bull market by the usual definition, and a further rally in shares and a fall in bond yields after a pause would be exactly the loosening the committee wants to avoid. Officials' new projections, published with tomorrow's decision, will show how many of them expect to raise rates again this year.

The strongest case for the Fed is that its credibility is higher than in 2006, after a year of increases larger than markets expected at almost every stage. If the dots show a clear majority for more tightening, traders may take the threat at face value for a few weeks. That buys time only until the next inflation print.

A Fed that pauses while talking tough will probably fail to convince markets. Bond yields will drift lower and financial conditions will ease, handing back months of tightening before the committee next meets in late July.