Over the last several quarters we have seen rising inflation and watched as The Fed has raised interest rates in response. Theoretically, higher interest rates should be a drag on the economy, thus bringing inflation down. As we have discussed several times, the balancing act is to raise the Fed Funds rate enough to slow the economy without sending it into a recession. There is always commentary on the Fed’s actions; did they raise too soon or too slowly, too much or not enough, when will they begin lowering rates again? The only thing that most economists can agree on is that whatever the Fed does, it was probably wrong. Let’s look at where we are now.
Although the most common measure of inflation is the Consumer Price Index (CPI), the Fed typically refers to the Personal Consumption Expenditures Index (PCE). The difference between the two is that CPI uses a narrower definition of consumer expenditures and only considers urban expenditures made directly by consumers. In contrast, PCE considers expenditures made by urban and rural consumers as well as expenditures made on their behalf by third parties. Below is a chart of the PCE Index [blue line] and the PCE Index excluding food and energy [red line, “Core PCE”] for the past three years.
Because food and energy prices are more volatile than other components, it is not surprising to see that the PCE inflation rate has been both below and above the Core PCE inflation. The Core PCE peaked in the first quarter of 2022 while the PCE rate peaked in the following quarter. The important thing to note is that both measures of inflation are trending downward.
The obvious question is what will happen next? We can assume that rising interest rates have caused slowdowns in certain parts of the economy which, in turn, have caused a slowing rate of inflation. The chart below shows us three important factors. First, the increase in the Fed Funds rate from February 2022 to the present is the steepest increase over the past 30 years. Second, at the last FOMC (Federal Open Market Committee) meeting on June 14, the Fed held the Fed Funds rate constant. However, in Fed Chair Jerome Powell’s remarks that afternoon, he stressed that a decision hasn’t been made whether to continue pausing next month or hike interest rate. Third, historically when the Fed Funds rate plateaus for a few months (2001, 2008, 2019) the next Fed move is to reduce rates. The one exception to this rule is from December 2015 to November 2016 when the rate held steady at 50 basis points (0.5%) and the Fed resumed hikes during 2016. However, this was after a 6-year period of flat Fed Funds rates.
Because of this, investors have been betting the Fed will cut interest rates later this year, but Powell poured cold water on that scenario during his recent remarks. “Inflation has not really moved down. It has not reacted much to our existing rate hikes. We’re going to have to keep at it,” he said. Further, “[while] it will be appropriate to cut rates at a time when inflation is coming down really significantly, we’re talking about a couple years out.”
Just as importantly, not a single Fed policymaker forecast a rate cut this year, he said, adding that he doesn’t think a cut is appropriate. After raising rates by a historic three-quarters of a point in four consecutive meetings, the Fed raised rates by a half point, then a quarter point, and paused. If they raise rates again during the July meeting, which Powell suggested was probable, it would be almost unprecedented.
Powell emphasized that the pause is “a continuation” of the Fed’s mission to get inflation down to 2%, and not simply a planned “skip.” While Fed officials voted unanimously to hold rates steady in June, most estimate that the Fed Funds rate will top out at a range of 5.63-5.87% in 2023. That indicates there will likely be at least one additional rate hike in 2023, and possibly more, depending on the size of the increase.
It is generally assumed, and Powell said, that rates will have to continue to rise in order to bring inflation down to acceptable levels – so why the pause? Possibly it was to allow the markets to catch their collective breath after last month’s “will the U.S. default?” excitement. Some have speculated that it was more politically driven but have not identified any political gains to come from it. For now, it is simply an unusual move during a very unusual period – which might mean nothing at all when we look back in the future.