With inflation cooling and unemployment rising in the United States, investors are betting that the Federal Reserve will cut interest rates. At the time of writing, market prices imply a less than 2 percent chance that the Fed will not cut rates at its policy-setting meeting in September, and even a 7 percent chance that the Fed will cut rates at its next meeting later this month.
The argument for cutting rates is simple. As measured by the consumer price index (CPI), the US had no inflation in May and deflation in June. At the same time, the unemployment rate has been rising since last summer. At 4.1 percent, it is 70 basis points above its post-pandemic low. If the unemployment rate rises a little, it will rise a lot, which is why many believe the Fed should declare victory in the war on inflation and begin the cutting cycle. But this view, while reasonable, is flawed because it misreads the outlook for inflation and the labor market. The Fed should not be cutting rates in September, and certainly not this month.
The Fed targets the personal consumption expenditures (PCE) price index, not the CPI. Like CPI inflation, core PCE inflation slowed in May (June data not yet available). But by that measure, monthly prices likely rose about 0.2 percent in June. By my calculations, if that pace continues, underlying inflation will remain between 2.6 percent and 3 percent for the rest of 2024, well above the Fed’s 2 percent target.
In addition to the uncertainty about whether inflation will move toward the Fed’s target in a sustainable manner, the underlying 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. Fixed income streams are robust, and asset owners have seen an explosion of wealth from homes and stocks. All of this will support consumer spending, putting upward pressure on prices. Moreover, after stronger-than-expected retail sales for June, the Atlanta Fed’s GDPNow model projects real economic growth of 2.5 percent in the second quarter. This growth rate is expected to put upward pressure on prices.
Yes, the labor market is weakening, but it’s still strong. By my calculations, demand for labor continues to outpace supply. Vacancies are normalizing, but they’re still 17 percent higher than they were before the pandemic. This is reflected in wage inflation. Average wages rose 3.9 percent year-over-year in June. While wage inflation (by this measure) has fallen 80 basis points over the past year, wages are still growing faster than the Fed’s target for consumer price inflation.
Certainly, the combination of cooling inflation and a softening labor market suggests that less restrictive policy is desirable. But what matters for monetary policy is overall financial conditions, not just the federal funds rate. Since the Fed’s pivot in November, rising stock prices and declining long-term interest rates and credit spreads have eased financial conditions considerably. Much of the financial tightening caused by the Fed’s relatively high policy rate has been undone.
Markets are doing the Fed’s work. Fed Chairman Jerome Powell said this in testimony to Congress last week: “It feels like the policy is constraining, but not extremely constraining.”
Current economic conditions do not indicate that the Fed should cut rates in the next two months. Instead, the implication is more modest: rising unemployment and underlying inflation below 3 percent suggest that the Fed should start paying attention to both sides of its dual mandate.
It may not be time to cut rates yet, but the Fed should be prepared to do so — especially if the labor market takes a dramatic turn for the worse, or if the next two PCE readings provide clear evidence that underlying inflation is moving sustainably toward the Fed’s target. But the risk of inflation remaining above 2.5 percent is too great for policymakers to cut rates now.
The Fed has entered the final mile of its fight against inflation. With its credibility at stake, it cannot falter before it reaches the finish line.
The author is director of economic policy studies at the American Enterprise Institute. ©Project Syndicate, 2024
First print: Jul 19, 2024 | 10:49 PM IST