Change of View: Fed on Hold Through 2025

Summary

• The immigration surge has been the main driver of the recent episode of disinflation with above trend growth.
• With the immigration surge over, GDP growth is likely to slow about 0.75 ppt over the next 12 months, wage growth will remain stuck around its current level and cost pressures will continue.
• Demand pressures, as shown by the worsening of the external deficit, will also contribute to inflation stickiness.
• We do not know enough about the incoming Trump administration’s economic policies to assess whether they will add to already existing inflationary pressures

Market Implications

• I expect the Fed to remain on hold through 2025, against the market pricing three cuts.
• I agree with markets pricing about 70% chance of a 25bp cut in December.

Disinflation Reflects Positive Supply Shocks

In this note I argue that, largely due to the end of the immigration surge, inflation is likely to remain stuck around its current levels, even without additional inflationary impulses from the incoming administration. This will prevent the Fed cutting as planned in 2025.

The simplest way to explain inflation is as a persistent imbalance between aggregate demand and supply (Charts 1 and 2). The combination of disinflation and strong growth over the past year suggests disinflation has reflected more a positive supply shock (outward shift in the supply curve) than a negative demand shock (inward shift of the demand curve).

I think the three key positive supply shocks that drove the disinflation are:

1. The unwinding of the pandemic imbalances which are now over.
2. An increase in productivity that could reflect adaptation to labour shortages during the pandemic, a greater share of voluntary part time work, and the impact of AI. I intend to explore this topic in future research.
3. A surge in low skill, unrecorded immigration.

Immigration Surge Drove Disinflation

Unrecorded immigration is difficult to measure but has been substantial over the past few years. The Congressional Budget Office (CBO) estimates net immigration to the US was 2.6mn in 2022 and 3.3mn in 2023, up from a 0.9mn annual average during 2010-19 and compared with a civilian population of 260mn in 2019. This surge reflects largely illegal immigrants and asylum parolees awaiting proceedings in immigration courts, which can take a few years. The current immigration court backlog is 3.7mn cases, including 1.6mn asylum cases.

Immigration has an ambiguous impact on inflation. On the demand side, it probably prevented a recession caused by a hangover from the 2021 consumption binge.

Consumption per worker fell after 2021, and what kept total consumption growing strongly was employment growth (Chart 3. I have used NFP since employment in the household survey does not take into account the immigration surge). Employment growth has kept growing above pre-pandemic trends, even after the economy had returned to full employment in Q4 2021.

Immigration could also have added to the demand for housing, which is in structural shortage, and explain part of the delayed disinflation in housing costs, as suggested by Fed Governor Bowman.

On the supply side, immigration has added to labour supply and kept wage growth, and therefore services inflation, lower than otherwise. Real wage growth was much lower in the recovery from the pandemic than in the recovery from the GFC (Chart 4).

In addition, the spread between low and high wage growth, which had widened in the early stages of the pandemic, has been narrowing after 2022 and is now well below its pre-pandemic level (Chart 5). This could reflect that low skill migrants compete with low wage workers already established in the US.

On balance, though migrants have likely added more to supply than demand, as they have partly saved part of their income. Immigration likely was a key driver of the recent disinflation (Chart 6).

Immigration Surge Over

However, in June 2024 the Biden administration implemented measures effectively closing the border, as shown by a decline in Border Patrol encounters (Chart 7). As a result, the migrant surge has ended, which could explain the recent and marked slowdown in NFP, 150 th. in Q3, against above 200 th. in H1 (Chart 8). In addition, the slowdown in NFP was not accompanied by a rise in unemployment, which suggests it was supply driven.

If my view is correct, growth is likely to slow while inflation remains sticky around current levels.

The job market is likely to remain tight despite slower NFP growth, which suggests wage growth could remain stuck around the current 4%.

Specifically, I expect to see:

• NFP slowing to about 130k, which is the CBO estimate for 2025 average and assumes no mass migrant expulsions.
• No significant increase in unemployment.
• An increase in the job finding rate; decreases in uninsured unemployment, in the spread of Hispanic over Caucasian unemployment, and in the spread of foreign-born unemployment relative to native born. These would be a reversal of the pattern of higher unemployment as a result of undocumented migrants, largely Hispanic, taking longer to find jobs and therefore raising uninsured unemployment (see NFP review).

With less immigration, GDP growth is going to slow. Based on the above NFP projections, NFP growth could slow to about 1% over the next 12 months, from 1.7% in the past 12 months. Assuming no change in productivity growth, this would bring GDP growth to about 2.25% from current 2.75% (Chart 9).

While sticky wage growth would keep cost pressures strong, demand pressure could build up further.

Overheating Could Worsen

I have been highlighting risks of overheating since February. These have finally materialized as shown by the worsening external balance, which is the mirror image of the domestic savings imbalance (Chart 10). The resource pressures reflect largely the combination of exceptionally large budget deficit and the ongoing corporate investment boom.

The risk is that, spurred by the incoming Trump administration’s pro-business policies, corporate investment could pick up further.

Incoming Administration Policies Could Add to Inflation Pressures

While President-elect Donald Trump has clearly set out the broad themes of his economic program: tax cuts, deregulation, tariffs, mass deportation of undocumented migrants, there is still much we do not know.

For instance, the announced deportation of 11mn illegal migrants would create labour shortages worse than during the pandemic, when the labour force contracted 9mn workers. Such a large decrease in the labour force would bring about a deep economic contraction and high inflation.

In reality, mass deportation on such a scale is unfeasible over a short period of time: annual deportations reached 500 th. under the Obama administration, fell to 300 th. during the first Trump administration and to 100 th. under the Biden administration.

Similarly, steep and unpredictable changes in tariffs would have more of a negative impact on growth and inflation than tariff increases implemented gradually in a stable regulatory framework.

Lastly, tax cuts that widen the budget deficit would see stronger overheating and inflationary pressures, adding to the risks the tariff increases translate into inflation acceleration rather than a one-off increase in the price level.

In sum, there is a version of Trump’s program consistent with strong growth and macroeconomic stability but we do not know if this version will be implemented.

That said, I believe inflation will turn out sticky even if the Trump administration implements the benign version of its economic plan.

Market Consequences

The Fed has given itself the next two years to bring inflation back to target. It expects to cut four times next year based on inflation heading down to about 2.25% by Q4 2025. By contrast, based on the above analysis, I expect core PCE to remain stuck in a 2.5-3% range and I believe this will prevent the Fed cutting. My view compares with the market pricing three 25bp cuts in 2025.

I still expect the Fed to cut in December due to inflation remaining within its comfort zone, around 2.8% or below. The market is pricing about 70% chance of a December cut, roughly in line with my degree of conviction.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)