Fed pause hopes rise as inflation eases to 2-year low in May, but all is not well as yet: Here's why

US consumer prices rose moderately in May, thus boosting bets on interest rate pause by the Federal Reserve but the US central banks shouldn't see the latest macroeconomic data as a reprieve.

The Bureau of Labour Statistics on Tuesday released the US Consumer Price Index (CPI) inflation data at 4% beating the expectations of 4.1%. Core prices increased 5.3%, falling in line with the expectations.

It was the lowest reading in more than two years and caused investors to all but seal their view the U.S. central bank will hold the benchmark federal funds rate steady at its current level between 5% and 5.25% at this week's meeting.

"The expected softening in US CPI has materialised, with both the core and headline monthly readings printing in line with expectations. And the sharp fall in the annual headline rate means annual price increases are now growing at their slowest pace since March 2021,” said Stuart Cole, Chief Macro Economist at Equiti Capital.

Last month, the Consumer Price Index (CPI) saw a modest increase of 0.1%, primarily due to a decline in gasoline prices. In April, the CPI had experienced a larger gain of 0.4%.

In June 2022, the annual CPI reached its peak at 9.1%, which was the largest increase since November 1981.

Economists surveyed by Reuters had predicted that the CPI would rise by 0.2% last month and show a year-on-year increase of 4.1%.

Recent labor market data has presented a mixed picture. While non-farm payrolls experienced a solid increase in May, the unemployment rate rose to a seven-month high of 3.7%, up from April's 3.4% which had marked a 53-year low.

The Wall Street prediction of a rate hike pause tomorrow after the FOMC meeting is now likely but a deep dive into the data and statistics tells another story. The Owners Equivalent Rent (OER) has elevated at 0.52 per cent MoM. YoY core inflation stood at 5.3% vs the 5.2% consensus.

A pause might be coming in June meeting but according to the data, investors are still predicting another hike in the month of July as the underlying core inflation seems to be stuck at 4.5-5%.

“It looks like the trend is just moving in a slower pace, but we expect that to continue. If it doesn't, then that's where Fed tightening comes back into play. I'm not sure it's going to be driven by inflation per se, because again, the core is going to stay sticky for a while. It's really going to be more the real side economy that will dictate whether they re-enter and hike again later this year,” said Joseph Lavorgna, Chief US Economist of SMBC Nikko Securities.

Peter Garnrt, the Head of Equity Strategy at Saxo Bank, said, “If you look at what the market is pricing, no change tomorrow and then it is leaning in favour of a rate hike in July. The problem is that some of the FOMC voting members have said themselves you need sustained low inflation levels and for them to even begin contemplating cutting rates with inflation report like what we're seeing today, I don't think it's possible for the FOMC to cut the policy rate this year.”

“The only path from here that could lead to an interest rate cut this year would be if there is some crisis on our hands, something unexpected is happening to the economy,” he added.

Brian Jacobsen, Chief Economist at Annex Wealth Management said, "Unlike the employment situation, which continues to defy expectations, inflation numbers came in consistent with expectations."

“Not only should the Fed skip tomorrow’s hike, they should just skip the entire meeting. The data ever so slightly tilts things towards this not just being a skip, but a full-blown hold,” Jacobsen added.

Since prices began accelerating in 2021, the Fed has waited for a series of changes to help ease the pace as the economy reopened from the pandemic and established a new balance.

Some of those changes have happened. Supply chains for goods are largely repaired, and the pace of goods price inflation has eased. Global food and energy prices have moderated from shocks around Russia's invasion of Ukraine.

But the U.S. services market, more labor dependent than other parts of the economy and still experiencing worker shortages and rising pay, isn't there yet.

For the Fed that presents a tough judgment over whether to move interest rates higher and try to break inflation faster, or stop at a slightly lower rate for a longer period in hopes inflation will gradually subside without major economic damage in the form of rising unemployment.

(Inputs from Reuters)

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