It’s been a while since Jerome Powell, the Chair of the Federal Open Market Committee (FOMC) has been comfortable saying clearly and concisely that it was time for the Federal Reserve to lower its policy interest rate. But he did exactly that in his talk on August 23rd at the annual economic symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole Wyoming.
A few minutes into his presentation, Powell stated “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.” The market took Powell’s words and body language to mean that the Fed funds rate is going down soon, and probably by quite a bit before year-end. Data compiled by Bloomberg have the market betting that the funds rate will be 30.6 basis points (bps) lower than today in September, 63.5 bps lower in November, and 98.4 bps lower in December — the months of the FOMC’s remaining three scheduled meetings this year.
The size of the moves in short rates market participants are now betting on look very aggressive given the current strong pace of economic growth in the U.S. – nominal GDP grew 5.87 percent versus the year-earlier quarter in Q2.2024 (blue line below). That growth rate is about 55 bps above the level of the Fed funds rate (red line). During the past forty years the Fed, has only started to cut rates twice when GDP growth exceed the funds rate, once in 1998 and again in 2019 (see chart),
and in both of those instances, PCE inflation was running well below the 2.0 percent level (see chart above). The start of the other four easing cycles – in 1984, 1989, 2000 and 2007 – all occurred after the nominal growth rate had slowed to a pace below that of the spot Fed funds rate. The current alignment of comfortably strong growth and PCE inflation that appears to have stabilized around the 2.5 percent level seems like an odd time to start an easing of monetary policy when viewed through the lens of Federal Reserve behavior in the post-Volcker era. So why now?
American labor now has friends at the Fed
The stated rationale for beginning to cut interest rates this month is a high level of confidence that the Fed’s preferred measure of inflation is on a glide path towards their 2 percent target combined with a notable increase in the unemployment rate and weakening of some measures of labor costs, like average hourly (see table below). Powell told us in Jackson Hole that: “It seems unlikely that the labor market will be a source of elevated inflationary pressures anytime soon.” And went on to say that: “We do not seek or welcome further cooling in labor market conditions.” This last sentence spoken by the FOMC chair was no doubt welcome news to most folks living and working in America. But is the path of medium-term U.S. inflation really locked-in to a path that brings us to a stable rate around 2 percent, and is the U.S. labor market cooling in a way that suggests the economy is on the cusp of a significant slowdown in growth that warrants a cut in interest rates? We have our doubts.
Early data for third quarter growth look pretty good so far. Personal consumption expenditures grew 5.3 percent versus the year earlier level in July as overall personal income expanded by 4.5 percent, right in line with observed income growth over the past year or so. U.S. economic growth may be set to slow, but at this point it’s a forecast, not something visible in high-frequency data.
|
Price & labor cost trends |
|||||
| percent change vs. 12 months earlier | |||||
| JULY ’22 | JAN ’23 | JULY ’23 | JAN ‘ 24 | JULY ’24 | |
| GDP deflator | 7.65 | 6.42 | 3.48 | 2.64 | 2.64 |
| PCE deflator | 6.62 | 5.48 | 3.31 | 2.48 | 2.50 |
| CPI | 8.45 | 6.36 | 3.27 | 3.11 | 2.92 |
| CPI energy | 32.6 | 8.59 | -12.5 | -4.34 | 0.96 |
| CPI energy commodities | 44.3 | 3.15 | -20.6 | -6.79 | -2.08 |
| WTI – spot | 40.2 | -6.13 | -25.1 | -5.08 | 7.53 |
| CPI electricity | 15.4 | 11.6 | 3.14 | 3.82 | 4.86 |
| CPI shelter | 5.73 | 7.90 | 7.67 | 6.07 | 5.03 |
| PCE services prices | 5.14 | 6.00 | 5.15 | 4.02 | 3.74 |
| PCE durable goods prices | 5.56 | 0.60 | -0.98 | -2.37 | -2.47 |
| Import prices – durables | 3.34 | 0.53 | -0.52 | -0.94 | -0.84 |
| Dollar index | 8.57 | 4.14 | –3.54 | 0.64 | 4.48 |
| LABOR & LABOR COSTS | |||||
| Average hourly earnings | 6.55 | 5.24 | 4.95 | 4.70 | 3.82 |
| Median hourly wages | 6.30 | 6.20 | 5.30 | 4.70 | 4.50 |
| Unit labor costs | 6.09 | 4.43 | 3.59 | 1.65 | 0.46 |
| Labor productivity | -2.40 | -1.90 | 1.30 | 2.70 | 2.70 |
| Labor force | 1.55 | 1.38 | 1.86 | 0.85 | 0.79 |
| Native born | 0.42 | 1.16 | 1.33 | 0.04 | -0.20 |
| Foreign born | 6.97 | 2.36 | 4.14 | 4.34 | 5.34 |
| Employment-household survey | 3.56 | 1.98 | 1.83 | 0.60 | 0.03 |
| Unemployment rate – level | 3.5 | 3.4 | 3.5 | 3.7 | 4.3 |
Unemployment is clearly higher now than it has been during the past two years. But the cause isn’t contraction in the quantity of American jobs, it is steady growth in the number of people looking for work (the measured labor force), driven by immigrants to America seeking jobs (see table above). Initial claims for unemployment insurance totaled 231,000 for the week ending August 24th, a relatively modest number and essentially the same as level as a year ago. The observed stagnation of employment growth identified in the household employment survey looks to be the result of unusually strong productivity growth in recent quarters, not a weakening of demand in the economy.
Growth in average hourly earnings has slowed to less than 4 percent, but median wages continue to grow at 4.5 percent (see table). Average wage increases are being held down by slower wage growth among lower income Americans. If immigration is aggressively curtailed, as promised by one candidate for President, should we expect this trend to continue? And even if immigration does continue at a rapid pace, union activity among service workers is now fighting against this trend.
Away from the labor market, we see reasons why inflation is likely to stay above the Fed’s 2 percent target in coming years. Most important in this regard is housing. Experts in the field estimate there is now a 4-to-5 million shortage of housing units and investment in housing is running at a low level relative to the size of the economy (see chart). With this mismatch between the demand and the supply of housing, it is unlikely we will see a sustained slowdown in the rate of increase in shelter costs on a nationwide basis. The existing market structure that is providing housing to Americans is simply not bringing supply and demand into balance with relatively stable prices.
Electricity is another segment of the U.S. economy where demand looks to be growing at a faster pace than available supply, exerting upward pressure directly on household living expenses and indirectly on the costs of production throughout the U.S. economy. As with housing, the existing market structure in the U.S. may not be capable of delivering a rapid expansion of electricity output at relatively stable prices. (For a complete discussion of why we believe 2 percent inflation rate is a not a realistic goal in the 2020s, see our research note from April 2024).
The cost / benefit of the Federal Reserve’s shift in priorities
Maybe U.S. growth is about to slow significantly and maybe inflation is, in fact, on its way to 2 percent – these outcomes would certainly fit nicely with the latest economic projections of the FOMC published in June when they were projecting GDP growth of 2.1 percent in the fourth quarter of this year and a 5.1 percent Fed Funds rate at year end. But even if this isn’t where the U.S. economy is headed, there may be a reason why the Fed would break with past behavior and telegraph a cut in the Federal funds rate is imminent even with growth remaining strong and inflation still above target – the upcoming U.S. election.
Weighing in on the relative merits of candidates for President is a taboo topic for monetary policy makers. We know that. But it is hard to imagine that many members of the FOMC are excited about the prospect of Donald Trump living in the White House again given his stated desires to increase the President’s influence and control of U.S. monetary policy and widely-held expectations that a Trump Presidency could bring significant policy changes – higher import tariffs, restrictions on immigration, advocating a weaker dollar – that could frustrate the Federal Reserves price stability ambitions. Alternatively, a Harris Presidency likely represents continuity. The Federal Reserve, as an institution, prefers stability and operational freedom.
The FOMC meeting in mid-September is the last opportunity to try to strengthen growth ahead of the U.S. election if that is, in fact, an unstated policy goal. A cut in short rates in September can, after all, be reversed quickly if growth remains strong and inflation turns back up. And gauging how much an interest rate cut will impact growth and inflation in the short-term is challenging. Financial conditions in the U.S. are already extremely accommodating (see chart below).
We seem to be moving into unexplored territory now. With a short-term, “data dependent” monetary policy framework, things can change quickly. Monthly economic data tends to be volatile, and so the market’s – and the Federal Reserve’s — views on future interest rates can change quite quickly. We expect volatility in fixed-income markets will remain elevated for the foreseeable future.
Douglas Cliggott | Provincetown, MA | 5 September 2024
While we make every effort to ensure that the analysis in this note is as accurate as possible, we do not guarantee that the information contained is either complete or correct. The material has been provided for informational and educational purposes only. The information is not intended to provide or constitute investment, accounting, tax, or legal advice.