How curved is the curve?

The payroll data came out exactly like Jay Powell would probably have wanted them: the downward revision to the previous months in job creation solidifies a move into below-trend territory, while a lower-than-expected wage print came as an additional boon. It would now take a very bad surprise in the inflation print for August to convince the FOMC to hike again on 20 September, and this adds to our belief that “peak Fed Funds” was hit in July.

We explore this week in more details the “Waller hypothesis,” i.e., the possibility that US inflation could go back to 2% with merely a decline in job opportunities – i.e., the possibility to change to new jobs – rather than a decline in existing jobs. A paper by Benigno and Eggertsson suggests that the Phillips curve gets particularly steep once job vacancies exceed the number of employment seekers, providing a persuasive explanation of the recent inflation wave. This could be good news: indeed, symmetrically, a steeper curve would be consistent with a swift decline in inflation once labour market loosens via a decline in openings without necessarily entailing much job destruction. This approach does not consider second-round effects though, such as the memory of the inflation shock which could trigger some wage/inflation catch-ups. In any case, even if they have improved, indicators of labour market tension such as the job opening and quit rates are still visibly above their pre-Covid levels. We think the Fed will err on the side of caution – consistent with our long-held view that rate cuts will take their time.

Arguably, the same phenomena could be at work in the Euro area. We note however that in her speech last week, Isabel Schnabel focused on another approach to the Phillips curve, based on firms’ strategic pricing behaviour, which provides a more hawkish alternative to the Benigno-Eggertsson model. With core inflation only marginally receding, the ECB hawks are not lowering their guard, even if some of them – including Schnabel – now accepts the possibility – but not the certainty – of a “skip” at the September meeting (but a skip would not necessarily be the prologue to a plateau but could be a short pause).