US payrolls and inflation point to a 0.25% rate increase in May

The message from the March labour market and CPI data is that the US economy remains robust and inflation is not falling fast enough. The Federal Reserve cannot yet declare victory over inflation and an 0.25% increase in the fed funds rate at its May meeting is likely.

The resilience of employment, which grew by 236k, decreased worries of an imminent recession (see Chart 1). Although the job market lags the business cycle, it is nonetheless notable that the unemployment rate fell to 3.5%. Another positive in the job market report is the moderation in wage growth to 4.2% year-on-year, the smallest increase in almost two years.

Chart 1. Employment and unemployment rate

Source: Refinitiv and EFGAM calculations.

The CPI data only partially reassured markets on the inflation outlook. Headline inflation dropped to 5% yoy, the lowest since May 2021, but remains well above the Fed’s 2% target (see Chart 2). The fall was due to energy and food prices; excluding these items, core inflation rose to 5.6% yoy. Furthermore, the core CPI increased 0.38% month-on-month, more than double the monthly rate consistent with the Fed's definition of price stability. 

Chart 2. Main contributions to US CPI inflation (yoy)

Source: Refinitiv and EFGAM calculations.

Once again, core inflation was boosted by the shelter component, which rose 0.6% mom. However, this is a moderation from recent months and suggests that, with the usual lag compared to property prices, housing prices will soon become disinflationary.

However, upward pressures on underlying inflation remain. Prices of core services, excluding shelter and energy, slowed to 5.9% yoy, but their rise is still too rapid. Furthermore, while the March monthly increase moderated from February, the average of the last three months was 0.37%, up from 0.33% in the three months to December (see Chart 3). The minutes of the March FOMC meeting report that participants saw "little evidence" that core services inflation was slowing, and the latest CPI data confirms that conclusion.

The Fed has recently linked inflation in core services to sustained wage growth. The slowdown in the latter could therefore be encouraging. However, it is not clear whether wage developments influence the prices of core services (see Chart 3). In the period since 2001, the correlation between the quarterly average of the monthly changes in wages and the core services CPI is slightly negative, and this is true also in the post-Covid period.¹ 

Chart 3. Wages and core services CPI (yoy)

Source: Refinitiv and EFGAM calculations.

In conclusion, March labour market and CPI data show a still healthy US economy, despite the banking sector turmoil, and sustained inflation. It is too early for the Federal Reserve to conclude that the current level of the fed funds rates will bring inflation back to 2%. Another 0.25% hike at the May meeting looks likely, but increased uncertainty over the economic outlook suggests the Fed will keep all options open at subsequent meetings.

¹ In the sample period January 2001-March 2023, the estimation of a VAR(3) on the quarterly average of monthly changes in core wages and prices shows that the cumulated impulse response of core services prices to a standard shock to wages is not statistically significant . Rather, the Granger causality test suggests that the two variables influence each other.