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Economic Monitor – Weekly Commentary
by Eugenio Alemán

Debt ceiling: Common sense prevailed

June 2, 2023

Late on Thursday night, the U.S. Senate followed the House of Representatives in passing the deal brokered by the Biden administration and the Speaker of the House, Kevin McCarthy, and it will now go to the desk of the president to be signed, avoiding a potential global financial and economic crisis.

As we argued in our latest Thoughts on the Market (TOTM), the deal will have limited effects on economic activity over the next two years from reductions in government expenditures while helping to reduce economic and financial risks of default for, at least, two and a half years, which is not a small feat.

Furthermore, there are several mechanisms within the bill that will push Washington politicians to follow through on budget appropriations or risk further damage. However, these battles will not have the potentially disastrous consequences that a debt default would have had for the U.S. and the global economy.

In an ideal world, we would hope that we use this time wisely and put forward a long-term solution to our debt issues.

Markets and the next FOMC meeting

Markets expectations for the June FOMC (Federal Open Market Committee) meeting have been running wild. The day before the House of Representative passed the Fiscal Responsibility Act (FRA), a.k.a., the debt ceiling bill, market bets on the next Federal Reserve (Fed) move had gone to about 70% expecting a 25- basis point increase in the fed funds rate. The day after the House of Representatives passed the bill, almost 74% of the bets were for the Fed to stay put on interest rates during the FOMC meeting in June.

Today, and after the release of the nonfarm payroll for May, market bets are once again moving with the bets at 67.9% for a pause and 32.1% for a 25-basis point increase.1 Although today’s movement after the nonfarm payroll number seems rational, there was nothing in the FRA that could have pushed the Fed would move one way or the other.

True, as we argued in the TOTM, we believe that the agreement will be slightly disinflationary, but nothing that would have argued for a completely opposite view regarding expectations about the federal funds rate. Thus, we continue to expect the Fed to pause on its rate increase during the FOMC meeting scheduled for June 13-14 even after the strong May nonfarm payroll report as the rate of unemployment increased from 3.4% in April to 3.7% in June. However, we understand that the Fed’s decision will come down to the wire.

At that time, the Fed is also going to release the Summary of Economic Projections (SEP), which will help clarify its view regarding the economy, inflation, as well as interest rates expectations going forward.

Employment growth and inflation

We have continued to hear that one of the reasons for the Fed to keep increasing interest rates is that the labor market continues to be very strong. However, even if the labor market has remained strong, which it has, it hasn’t stopped inflation from slowing down since the peak in June of last year.

Although there has been research that has pointed to labor costs as one of the reasons for higher inflation, others have pointed out that labor costs are adding very little to current inflation or that there doesn’t seem to be a process indicating a wage-price spiral.2,3 Furthermore, a research piece from the Federal Reserve Bank of San Francisco from September of 2022 has also pointed out the changing components of wage inflation over time, showing that inflation expectations, in this case short-term inflation expectations, are now a much larger component of wage inflation than before the COVID-19 pandemic. 4 This is, perhaps, the most important reason why the Fed may consider continuing to increase interest rates. However, we still believe that the Fed will refrain from hiking during its coming June FOMC meeting as it continues to estimate the effects of last year’s increase in interest rates on economic activity.

Furthermore, as we argued above, wage pressures, while important, don’t seem to be the reason for high inflation or for inflation to continue to increase. However, it is, perhaps, one of the reasons why it has taken much longer for inflation to come back down.

Going forward, we are still expecting inflation to start moving lower at a faster pace as we expect shelter costs to have a lesser impact on inflation during the second half of the year. That is, we continue to expect the disinflationary process to continue unabated.

Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those Raymond James and are subject to change without notice the information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the U.S. Bureau of Labor Studies. Currencies investing are generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

The National Federation of Independent Business (NFIB) Small Business Optimism Index is a composite of ten seasonally adjusted components. It provides a indication of the health of small businesses in the U.S., which account of roughly 50% of the nation's private workforce.

The producer price index is a price index that measures the average changes in prices received by domestic producers for their output. Its importance is being undermined by the steady decline in manufactured goods as a share of spending.

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