Weekly Economic Outlook — Jun 8: Will Economic Headwinds Prevent Further Rate Hikes?

The labor market surprised to the upside in May, with non-farm payrolls expanding by 172,000 — beating even the most optimistic forecasts. In response, futures markets are now pricing in a quarter-point rate hike later this year and, more likely than not, another quarter-point increase sometime in 2027.

We think a rate hike would be both unlikely and ill-advised.

A solid report, not a barnburner

May's jobs print was good, but not extraordinary. True "barnburner" prints run in the 300,000 to 400,000 range. Even on a Keynesian framework — which assumes strong hiring directly stokes inflation — the reaction to this number looks overdone.

Inflation: temporary pressures over a moderate money base

CPI is up 3.8% year over year, and the Fed's preferred gauge, the PCE deflator¹, has run above 2.0% for more than five years. Strip out the temporary lift from the Iran war on energy prices, however, and the underlying setup looks consistent with a return toward the 2.0% target.

The M2 money supply is up 4.7% from a year ago, and just 3.2% annualized over the past three years. By comparison, in the decade before COVID — when inflation consistently ran below 2.0% — M2 grew at a 6.2% annual pace. In other words, money growth is already slow enough to bring inflation back under control over time.

The war has pushed oil prices sharply higher, lifting headline inflation. But higher oil is, mechanically, a tax on consumers: more dollars spent at the pump means fewer dollars available for other goods and services, which over time pushes those other prices down.

Why headline inflation can stay sticky in the short run

In the short run, consumers have absorbed the shock by saving less. The personal saving rate was 4.3% in January and fell to 2.6% by April. That sounds small, but if the lower rate persists for a year, household saving would fall by roughly $400 billion versus the January pace. That drawdown gives consumers temporary room to pay higher energy bills without forcing other prices lower yet.

This is not the "transitory" call from a few years ago. Back then, PCE inflation peaked above 7.0% — a forty-year high — and M2 had ballooned by roughly 40%. The starting conditions today are very different.

Wages and trimmed inflation point lower

Despite strong hiring, average hourly earnings are up just 3.4% from a year ago, matching the slowest pace in five years. That is consistent with 2.0% inflation plus the long-run 1.5% productivity trend. If actual productivity growth is currently running above trend — a topic we will revisit — 3.4% wage growth is an even stronger signal that policy is already tight enough to pull inflation back to target once the Iran war fades.

Other gauges agree. The Dallas Fed's trimmed mean PCE², which strips out the most volatile categories, is up only 2.4% year over year, down from 2.6% in April 2025.

What the Fed is likely to do

Newly confirmed Chair Kevin Warsh likely does not have the votes to cut short-term rates even if he wanted to. But given moderate wage growth and well-behaved trimmed-mean inflation, he likely does have the political weight at the FOMC³ to keep additional rate hikes off the table.

Raising rates here would compound an existing headwind. Consumer spending is already outrunning income growth, and higher oil prices are themselves a drag on activity. Tightening on top of that is hard to justify.

Market read

Friday's sell-off was about more than a hot jobs print. Equity valuations are stretched, and the idea that markets only move in one direction has never held up over time. We are not calling for a crash, but two-way risk is back.

Bottom line

The path of least resistance is for the Fed to hold. Money growth is moderate, wage growth is contained, and trimmed inflation is close to target. Headline inflation is being pushed around by an oil shock that will fade. A rate hike into that backdrop would be the wrong instrument for the wrong problem.

Footnotes

1. PCE deflator — the personal consumption expenditures price index. The Fed's preferred inflation gauge because it adjusts for shifts in what consumers actually buy, not just a fixed basket.

2. Trimmed mean PCE — an inflation measure published by the Dallas Fed that drops the categories with the largest price moves in either direction each month, leaving a steadier read on the underlying trend.

3. FOMC — the Federal Open Market Committee, the group within the Federal Reserve that sets short-term interest rates.