End of Act I: A Pause in Interest Rate Hikes?

On May 3, the Federal Reserve Bank increased the Fed Funds rate by another 25 basis points, to a range of 5.00% to 5.25%, and signaled it will likely not increase interest rates when it meets again in mid-June. The central bankers fully understand that monetary policy takes time to have an impact on the economy. This seeming pause, after more than a year of rate hikes, lets market participants digest the newest data and assess the effects that the rapid tightening has had on the war against inflation. While we move to intermission after Act I, we can plainly see the impact of this tightening in two ways: improving inflation numbers and bank failures. Yet, there is still a long way to go to achieve the Fed’s stated target of 2% inflation.

Fed Funds Effective Rate, 2020-23

Source: Board of Governors of the U.S. Federal Reserve System

Slightly less than 70% of the U.S. GDP is driven by private consumer spending. So, if we want to understand the trajectory of inflation in the United States, it makes sense to look closely at how consumers may spend going forward, rather than relying on backward-looking published data such as Consumer Price Index. We can glean some insights based on recent earnings releases from consumer goods multinational Procter & Gamble and hotel giant Marriott International. Both are consumer-dependent businesses that represent consumer-staple spending and discretionary spending, respectively.

P&G, which sells everything from toothpaste to laundry detergent to diapers, is the quintessential consumer-staple company and possibly one of the most accurate proxies for consumer spending and sentiment. During the company’s April earnings call, its CFO noted that “organic sales grew more than 7%. Pricing added 10 points to sales growth, and the mix was a modest positive contributor for the quarter. Volume declined 3 points, including a 1-point headwind from portfolio reduction in Russia.” What he’s actually saying: P&G increased pricing by 10% across the board during the quarter and saw very limited negative reaction, in the form of a 3% reduction in volume, from consumers. That’s a massive price increase in one quarter, and nearly double the Core CPI print of 5.5% in May.

Not to be outdone, Marriott, which has 30 brands and more than 7,000 hotels worldwide, announced some staggering results: year-over-year increases of 34% in RevPAR, or revenue per available room, and 11% in global ADR, or average daily rate. This means not only that more people are staying in hotels, but they are paying 11% more, on average, per hotel night. With these tailwinds, Marriott noted that it is “not seeing signs of a slowdown” and increased its full-year outlook for earnings, which had already finished 2022 with more than a 100% increase from 2021.

These rosy earnings reports are the result of very strong consumer spending, which will continue as long as consumers have jobs. The Bureau of Labor Statistics’ April unemployment report surprised nearly everyone, showing that non-farm payrolls rose by 253,000. That puts the unemployment rate at 3.4%, the lowest since 1969. A generally accepted threshold in the report is 200,000 new jobs; a report higher than this level represents a continuing tightening labor market, resulting in upward pressure on wages—and therefore inflation.

The Federal Reserve has done an admirable job in slowing inflation from 9.1% in June 2022 to 4.9 through April. As we’ve seen, the U.S. consumer is comfortable spending more money on everyday items. The only way to slow this down is through material job losses and deterioration in consumer demand. The first 4.2% reduction in inflation, since June 2022, has been relatively fast and easy, with limited job losses or economic contraction. Unfortunately, it’s likely the next 2.9% required to bring inflation to 2% could be slow and extremely painful, with more corporate failures and millions of jobs lost.