Soaring inflation upends Fed’s rate cut plans
This week’s Federal Open Market Committee (FOMC) meeting The Fed’s resolve will be testedWill the Fed stick to its forecast for one rate cut this year, or will it succumb to financial markets that are pricing in multiple rate cuts this year?
When the FOMC met in mid-June, Fed officials on average expected the federal funds rate to be 5.1% by the end of the year. One reduction from today’s 5.25% to 5.50% range.
Importantly, this represents a change in expectations from when the Fed last released its forecasts in March, when it projected rates to be 4.6% by the end of the year. Three 25 basis point rate cuts.
What happened between the March and June meetings was Inflation spiked at the start of the yearThis upended the Fed’s plans and raised doubts about whether inflation was really on track to reach 2% and would continue to fall despite the rate cuts. Rather than rushing to cut rates, Fed officials decided it would be prudent to wait until there was more evidence that inflation was indeed continuing to fall.
Rate cut expectations resurrected
Inflation has been falling since then. According to a “preliminary” estimate released last week, the personal consumption expenditures (PCE) price index rose at an annualized rate of 3.4% in the first quarter of this year, and 2.6% in the second quarter. Financial markets concluded that the first quarter was a “head fake.” It’s an anomaly that can be largely ignored.
The problem with this view is that we’ve been in this situation before: Preliminary PCE inflation figures for the fourth quarter of last year showed prices rising at 1.7%, down from 2.6% in the third quarter. Subsequent estimates have been revised slightly upward to 1.8%, leading the Fed and markets to expect multiple rate cuts this year.
Given the recent history of unexpected inflation spikes, It would be extremely reckless for the Fed to start cutting interest rates. The decision to cut rates after just one quarter of good data would be much safer for the Fed to leave rates where they are and wait another quarter or two to make sure inflation is truly and sustainably declining.
The economy is slowing, but not yet slowing
If the economy had taken a sharp downturn or shown signs of stress, things might have been different. Economic growth acceleratedGross domestic product, the government’s broadest measure of growth, rose 2.8% in the second quarter. Income after taxes and inflation rose 1%. Far from encouraging consumers to cut back on spending and engage in precautionary savings that sometimes lead to an economic slowdown, the economy is growing at a rapid clip. Savings rates have fallen.
Personal consumption expenditures – the government’s way of measuring consumer spending – rose 2.3% in the second quarter, up from 1.4% in the first three months of the year. Spending on durable goods surges Nonresidential fixed investment, a gauge of business confidence, rose 5.2 percent, including a strong 11.6 percent increase in business investment.
Recent data has done nothing to change the picture for an economy that is not in dire need of accommodative monetary policy. Retail Sales Auto sales beat expectations in June, with Core Control’s sales rising 0.9% from the previous month, an upward revision, and likely even better if not for a cyberattack on an auto dealership.
Industrial production also exceeded expectations. Manufacturing output surges It increased 0.4 percent, while May’s increase was revised upward to 1 percent.
S&P Global’s “flash” Purchasing Managers’ Index rose to 55.0 in July from 54.8 in June, the highest since April 2022. The services sector expanded at its fastest rate since March 2022 in July.
There has been a lot of talk about the labor market cooling, but it is important to remember that this is a very slow process. The unemployment rate has been rising slowly and unevenly, which looks more like a normalization of the labor market than a weakening of the market. This is completely different from the rise in unemployment caused by a recession.In most cases, this is accompanied by a sudden increase.
Given this economic situation, Fed officials will likely want to stick to their June forecastsBut because no forecasts will be issued at the July meeting, it will be up to the FOMC statement or Fed Chairman Jerome Powell’s press conference to reset market expectations. Powell will likely respond gently with a message of patience at his press conference, with a similar message coming from Fed speakers in the coming weeks.
But it’s also possible that the Committee is becoming more confident about inflation than we might think is reasonable, in which case the Committee may want to allow the market to believe that a rate-cutting cycle could begin in September. Indeed, doing so may be wise to avoid accusations that the rate-cutting cycle is “higher inflation.” “September Surprise” The rate cut will likely be seen as an attempt to boost the political fortunes of the Democratic presidential candidate.
