There are a lot of questions about Fed policy these days and where things might be headed. Here are some commonly asked questions I’ve been getting lately:
1) Why is the Fed considering a rate cut?
At Wednesday’s FOMC meeting the Fed stood by their estimate of 3 rate cuts in 2024. This took some people by surprise as recent inflation readings have come in a little hotter than expected and could justify higher rates for longer.
A little perspective is useful in all of this. Although the Fed’s target inflation rate is 2% the historical average inflation in the USA is about 3.3%. We’re at 3.2% on CPI. We’re at the average. So you could actually argue that inflation has already been defeated and we’re nearing a sustainable long-run inflation rate. But even so, the Fed’s overnight rate (FFR) remains at 5.5% which is quite restrictive. In fact, according to the Taylor Rule the Fed is now too tight. So I think they’re getting a little concerned about repeating the mistake of 2021 where many real-time metrics and the Taylor Rule said the Fed should be tightening and yet they delayed. Now we’re seeing the inverse of this and so the Fed is starting to think about the risk of staying too tight for too long.
And let’s not forget – even if they cut to 4.75% that would still be a relatively tight rate. So it’s not like they’d be flooding the system with cheap credit. After all, mortgage rates would still be at about 6% in that scenario and people aren’t going to climb over one another to get out of their 3% mortgages that they locked in so they can borrow at 6% for a new home. So housing, which is the largest credit market here, will still be relatively restrictive even after they cut by 1%. All credit markets will still be relatively tight with a FFR of 4.75%.
More importantly though, Core PCE is in a very obvious downtrend. Some people have pointed to other metrics which show inflation moving more sideways, but core PCE never stopped moving down and that’s the index the Fed most cares about. And I expect it to keep moderating lower in the coming year. So the Fed is trying to get ahead of this a little bit. They don’t want to wait until inflation is at 2% to cut because that could mean they’re behind the curve. So they’re considering cuts when core PCE is above target because they believe we’re headed towards the target. And we’re at 2.8% core PCE so it’s not unreasonable to begin thinking about cuts. So, I think they’re being thoughtful here. They’re comfortable with the long-term trend in inflation, believe it’s going lower, but they’re also not going to cut rates so sharply that they could spark a big resurgence in inflation.
2) Is the risk of a 1970s or 1940s double bump inflation scenario still a risk?
The reason the Fed hasn’t moved to cut just yet is because they’re still a little cautious about another flare-up in inflation. They don’t want to cut and then cause a big borrowing binge that could put upward pressure on prices. So they’re moving a little bit cautiously here. And as I noted above, any moves they do end up making are not going to be so dramatic that they cause a flood of consumption. Even if they cut they’ll still be relatively restrictive.
As for the risk of a double bump – I don’t see it. We’ve seen underlying employment metrics softening, but not crashing. Commodities are down 5% year over year. Regional Fed surveys show easing price pressures. Wages are slowing. And yet shelter inflation is still coming in at 6% even though we know shelter inflation has already fallen back to 0% in real-time rent metrics. So that means that shelter, which is 40% of CPI, is going to put this continued downward pressure on the overall index. In order to get a huge flare up in inflation that offsets that you’d need something really crazy to happen now like oil going to $300. Could something like that happen? Sure, but it’s not a baseline scenario. If anything, the baseline is that shelter continues to moderate and inflation creeps towards 2-2.5% over the coming year.
All in all they’re concerned about the risk of sticky inflation, but they’re not overreacting because their baseline expectation is still a move towards the low 2% range.
3) Has the Fed achieved a soft landing?
After botching the 2021/22 response I think the Fed has done a really nice job. I thought there was a higher risk of a policy mistake and that hasn’t come to fruition. That said, it’s still way too early to declare victory. The economy isn’t a plane that lands. It’s a plane that flies all the time and the best way to think of a 5.5% policy rate is that we’re still flying very cautiously to avoid the inflation turbulence. The Fed doesn’t want to be flying cautiously. They want to be at 3% or so where the plane can comfortably fly at full speed at a sustainable altitude. We’re not there yet.
So I think the right way to judge this is that they’ve helped the US economy avoid more major turbulence, but they still see storm clouds on the horizon and they’re still flying cautiously. If they get the policy rate back to 3% or so without causing a major economic problem then we declare mission accomplished and Jerome Powell probably goes into the history books as an all-time great Fed Chief.
4) Is the Fed abandoning their 2% target?
Sometimes I think people take the policy target too literally. For example, imagine being 200 pounds and having a target weight of 180 pounds by year end. If you got to 185 pounds you’d probably be proud of your achievement. Sure, you didn’t get all the way there, but you lost 75% of the weight you targeted. That’s really good! The same basic premise can be applied here. The historical inflation rate is 3.3% in the USA, but if the Fed gets inflation down to 2.25% then they’re still above target but well within a reasonable inflation range.
But more importantly, what the Fed wants to see here is that they’re trending in the right direction. They actually don’t want to go way below target because that could be indicative of something bad happening. If you overshot your weight target to 160 pounds you’re probably losing too much weight too quickly. So the Fed is cognizant of both risks – the risk they don’t get inflation down, but also avoiding the scenario where they remain so tight that the economy loses more weight than we want.
In any case, Powell made it 100% clear that they’re not abandoning the 2% target. But they want to see more evidence that we’re trending towards it before they start cutting.
5) Why did the Fed lift their growth and inflation outlook while also maintaining expectations of three cuts?
There was a lot of chatter after the FOMC meeting about how the Fed raised economic growth and inflation projections and still maintained the expectation of three cuts this year. This might not make sense at first blush, but I think people are reading into changes that are really inconsequential. For instance, their 2025 inflation projection didn’t even change. Neither did the 2026 projection. So part of this is accounting for the surprise upside readings in the January and February, which forced them to up their 2024 inflation projection slightly, but none of this changed their longer-run inflation projections. So I wouldn’t read into this too much. Their long-run projections remained the same for inflation and that’s why they’re sticking with their December expectation of three cuts in 2024.
6) If financial conditions are looser today than they were in 2022 then why are they considering cuts?
The Chicago Fed’s National Financial Conditions Index has been loose for much of the last few years and has gotten looser more recently. This index gets a lot of airtime, but really has no correlation to how tight Fed policy is and whether inflation is too high. For instance, in 2020 the index blew higher mainly because some of its underlying components like credit spreads, VIX and loan surveys surged. These things could be indicative of “tight” financial conditions, but really have no correlation with whether Fed policy and inflation is tight. In my view the main problem with this index is that it’s so broad and covers so many different indicators that it ends up being a coincident indicator that tells you more about how unstable financial markets are in real-time than anything about inflation and Fed policy.