The Fed has entered the final stretch of its fight against inflation, and with credibility at stake, it cannot afford to back down before reaching the finish line.
Photo: BloombergMichael R Strain
With inflation subsiding and unemployment rising in the U.S., investors are betting the Federal Reserve will cut interest rates. At the time of writing, market prices are suggesting less than a 2% chance that the Fed will not cut interest rates at its September policy meeting, and even a 7% chance that it will cut rates at its next meeting later this month.
The case for a rate cut is straightforward. As measured by the Consumer Price Index (CPI), the United States had no inflation in May and deflation in June. At the same time, the unemployment rate has been trending upward since last summer. At 4.1%, it is 70 basis points above its post-pandemic low. Since a small increase in unemployment can lead to a large increase, many believe that the Fed should declare victory in the fight against inflation and begin a rate cut cycle. However, while this view is valid, it misreads the outlook for inflation and the labor market and is therefore incorrect. The Fed should not cut rates in September, much less this month.
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The Fed targets the personal consumption expenditures (PCE) price index, not the CPI. Like CPI inflation, core PCE inflation slowed in May (June data is not yet available). However, using this measure, monthly prices may have risen by about 0.2% in June. By my calculations, if this pace continues, underlying inflation would hover between 2.6% and 3% for the remainder of 2024. This would be well above the Fed's 2% target.
In addition to the uncertainty about whether inflation is moving sustainably toward the Fed's target, the fundamental drivers of consumer demand remain strong. Low unemployment is boosting incomes. Average wages have been growing faster than consumer prices for more than a year, boosting household purchasing power. Bond inflows have been strong, and wealthy individuals are exploding with wealth from homes and stocks. All of this will support consumer spending and put upward pressure on prices. Moreover, following better-than-expected June retail sales figures, the Atlanta Fed's GDPNow model projects real economic growth of 2.5% in the second quarter. This growth rate would likely put upward pressure on prices.
The labor market has weakened, to be sure, but it remains strong. By my calculations, labor demand continues to exceed labor supply. Job openings have normalized but remain 17% higher than they were before the pandemic. This is reflected in wage inflation: average wages rose 3.9% year-over-year in June. Wage inflation (by this measure) has fallen 80 basis points over the past year, but wages are still growing faster than would be consistent with the Fed's consumer price inflation target.
Certainly, the combination of subdued inflation and a softening labor market suggests that a more accommodative policy stance is desirable. However, it is overall financial conditions, not just the federal funds rate, that matter for monetary policy. Since the Fed's shift in policy in November, financial conditions have eased significantly, driven by rising equity prices and declining long-term interest rates and credit spreads. Much of the monetary tightening caused by the relatively high Fed policy rate has been removed.
The markets are doing the Fed's job. “Policy is restrictive, but it doesn't appear to be excessively restrictive,” Fed Chairman Jerome Powell said in congressional testimony last week.
Current economic conditions do not suggest that the Fed should start cutting interest rates within the next two months. In fact, the indications are more modest. Rising unemployment and underlying inflation below 3% suggest that the Fed should start paying attention to both sides of its dual mandate.
While now may not be the time to cut rates, the Fed should be prepared to do so, especially if the labor market deteriorates dramatically or if the next two PCE readings provide clear evidence that underlying inflation is moving sustainably toward the Fed's goal. But the risks of inflation stagnating above 2.5% are too great for policymakers to cut rates now.
The Federal Reserve has entered the final stages of its fight against inflation, and with its credibility on the line, it cannot afford to back down before reaching the finish line.
The author is director of economic policy studies at the American Enterprise Institute. ©Project Syndicate, 2024
These are the personal views of the author and are not necessarily
