Category: Ch25: Monetary Policy

Economists vs. the Market in Predicting the First Cut in the Federal Funds Rate

The meeting room of the FOMC in the Federal Reserve building in Washington, DC.

As we’ve noted in several recent posts, the inflation rate has fallen significantly from its peak in mid-2022, as U.S. economic growth has been slowing and the labor market appears to be less tight, slowing the growth of wages. Some economists and policymakers now believe that by early 2024, inflation will approach the Fed Reserve’s 2 percent inflation target. At that point, the Fed’s Federal Open Market Committee (FOMC) is likely to turn its attention from inflation to making sure that the U.S. economy doesn’t slip into a recession.

Accordingly, both economists and financial market participants have begun to anticipate the point at which the FOMC will begin to cut its target for the federal funds rate. (One note of caution: Fed Chair Jerome Powell has made clear that the FOMC stands ready to further increase its target for the federal funds rate if the inflation rate shows signs of increasing. He made this point most recently on December 1 in a speech at Spelman College in Atlanta.)  There is currently an interesting disagreement between economists and investors over when the FOMC is likely to cut interest rates and by how much. We can see the views of investors reflected in the futures market for federal funds.

Futures markets allow investors to buy and sell futures contracts on commodities–such as wheat and oil–and on financial assets. Investors can use futures contracts both to hedge against risk—such as a sudden increase in oil prices or in interest rates—and to speculate by, in effect, betting on whether the price of a commodity or financial asset is likely to rise or fall. (We discuss the mechanics of futures markets in Chapter 7, Section 7.3 of Money, Banking, and the Financial System.) The CME Group was formed from several futures markets, including the Chicago Mercantile Exchange, and allows investors to trade federal funds futures contracts. The data that result from trading on the CME indicate what investors in financial markets expect future values of the federal funds rate to be. The following chart from the CME’s FedWatch Tool shows values after trading of federal funds futures on December 5, 2023.

The probabilities in the chart reflects investors’ predictions of what the FOMC’s target for the federal funds rate will be after the committee’s meeting on March 20, 2024. This meeting is the first after which investors currently expect that the target is likely to be lowered. The target range is currently 5.25 percent to 5.50 percent. The chart indicates that investors assign a probability of 60.2 percent to the FOMC making at least a 0.25 percentage cut in the target rate at the March meeting. 

Looking at the values for federal funds futures after the FOMC’s December 18, 2024 meeting, investors assign a 66.3 percent probability of the committee having reduced its target for the federal funds rate to 4.00 to 4.25 percent of lower. In other words, investors expect that during 2024, the FOMC will have cut its target for the federal funds rate by at least 1.25 percentage points.

Interesingly, according to a survey by the Financial Times, economists disagree with investors’ forecasts of the federal funds rate. According to the survey, which was conducted between December 1 and December 4, nearly two-thirds of economists believe that the FOMC won’t cut its target for the federal funds rate until July 2024 or later. Three-quarters of the economists surveyed believe that the FOMC will cut its target by 0.5 percent point or less during 2024. Fewer than 10 percent of the economists surveyed believe that during 2024 the FOMC will cut its target for the federal funds rate by 1.25 percent or more. (The Financial Times article describing the results of the survey can be found here. A subscription may be requred to read the article.)

So, at least among the economists surveyed by the Financial Times, the consensus is that the FOMC will cut its target for the federal funds rate later and by less than financial markets are indicating. What explains the discrepancy? The main explanation is that economists see inflation being persistently above the Fed’s 2 percent target for longer than do financial market participants. The economists surveyed are also more optimistic that the U.S. economy will avoid a recession in 2024. If a recession occurs, the FOMC is more likely to significantly cut its target than if the economy during 2024 experiences moderate growth in real GDP and the unemployment rate remains low.

One other indication from financial markets that investors expect that the U.S. economy is likely to slow during 2024 is given by movements in the interest rate on the 10-year U.S. Treasury note. As shown in the following figure, from August to October of this year, the interest rate on the 10-year Treasury note rose from less than 4 percent to nearly 5  percent—an unusually large change in such a short period of time. Since then, most of that increase has been reversed with the interest rate on the 10-year Treasury note having fallen below 4.2 percent in early December

The movements in the interest rate on the 10-year Treasury note typically reflect investors’ expectations of future short-term interest rates. (We discuss the relationship between short-term and long-term interests rates—which economists call the term structure of interest rates—in Money, Banking, and the Financial System, Chapter 5, Section 5.2.) The increase in the 10-year interest rate between August and October reflected investors’ expectation that short-term interest rates were likely to remain persistently high for a considerable period—perhaps several years or more. The decline in the 10-year rate from late October to early December reflects investors changing their expectations toward future short-term interest rates being lower than they had previously thought. Again, as in the data on federal funds rate futures, investors seem to be expecting either slower economic growth or slower inflation than do economists.

One other complication about the interest rate on the 10-year Treasury note should be mentioned. Some of the increase in the rate from August to October may also have represented concern among investors that large federal budget deficit would cause the Treasury to issue more Treasury notes than investors would be willing to buy without the Treasury increasing the interest rate investors would receive on the newly issued notes. This concern may have been reinforced by data showing that foreign investors, particularly in China and Japan, appeared to have slowed or stopped adding to their holdings of Treasury notes. Part of the recent decline in the interest rate on the Treasury note may reflect investors becoming less concerned about these two factors.

Can We Now Rule Out One of the Three Potential Monetary Policy Outcomes?

Federal Reserve Chair Jerome Powell (photo from bloomberg.com)

In a blog post from February of this year, we discussed three possible outcomes of the contractionary monetary policy that the Federal Reserve has been pursuing since March 2022, when the Federal Open Market Committee (FOMC) began raising its target range for the federal funds rate:

  1.  A soft landing. The Fed’s preferred outcome; inflation returns to the Fed’s target of 2 percent without the economy falling into recession.
  2. A hard landing. Inflation returns to the Fed’s 2 percent target, but the economy falls into a recession.
  3. No landing. At the beginning of 2023, the unemployment remained very low and inflation, as measured by the percentage change in the personal consumption expenditures (PCE) price index from the same month in the previous year, was still above 5 percent. So, some observers, particularly in Wall Street financial firms, began discussing the possibility that low unemployment and high inflation might persist indefinitely, resulting an outcome of no landing.

At the end of 2023, the economy appears to be slowing: Retail sales declined in October; real disposable personal income increased in October, but it has been trending down, as have real personal consumption expenditures; while the increase in third quarter real GDP was recently revised upward from 4.9 percent to 5.2 percent, forecasts of growth in real GDP during the fourth quarter show a marked slowing—for instance, GDPNow, compiled by the Atlanta Fed, estimates fourth quarter growth at 2.1 percent; and while employment continues to expand, average weekly hours have been slowly declining and initial claims for unemployment insurance have been increasing.

The slowing in the growth of output, income, and employment are reflected in a falling inflation rate. The following figure show the percentage change since the same month in the previous year in PCE price index, which is the measure the Fed uses to gauge whether it is hitting its 2 percent inflation target. (We discuss the reasons for the Fed preferring the PCE price index to the consumer price index (CPI) in Macroeconomics, Chapter 15, Section 15.5 and Economics, Chapter 25, Section 25.5.) The figure also shows core PCE, which excludes the prices of food and energy. Core PCE inflation typically gives a better measure of the underlying inflation rate than does PCE inflation.

PCE inflation declined from 3.4 percent in September to 3.0 percent in October. Core PCE inlation declined from 3.8 percent in September to 3.5 percent in September. Although inflation has been declining from its peak in mid-2022, both of these measures of inflation remain above the Fed’s 2 percent target.

But if we look at the 1-month inflation rate—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year—we see a much sharper decline in inflation, as the following figure shows.

The 1-month inflation rate is naturally more volatile than the 12-month inflation rate. In this case, the 1-month rate shows a sharp decline in PCE inflation from 3.8 percent in September to 0.6 percent in October. Core PCE inflation declined less sharply from 3.9 percent in September to 2.0 percent in October.

The continuing decline in inflation has caused some economists and Wall Street analysts to predict that the FOMC will not implement further increases in its target for the federal funds rate and will likely begin cutting its target by mid-2024.

On December 1 in a speech at Spelman College in Atlanta, Fed Chair Jerome Powell urged caution in assuming that the Fed has succeeded in putting inflation on a course back to its 2 percent target:

“The FOMC is strongly committed to bringing inflation down to 2 percent over time, and to keeping policy restrictive until we are confident that inflation is on a path to that objective. It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease. We are prepared to tighten policy further if it becomes appropriate to do so.”

In terms of the three policy outcomes listed at the beginning of this post, the third—no landing, with the unemployment rate remaining very low while the inflation rate remains above the Fed’s 2 percent target—now seems unlikely. The labor market appears to be weakening, which will likely result in increases in the unemployment rate. The next “Employment Report” from the Bureau of Labor Statistics, which will be released on December 8, will provide additional data on the state of the labor market.

Although we can’t entirely rule out the possibility of a no landing outcome, it seems more likely that the economy will either make a soft landing—if output and employment continue to increase, although at a slower rate, while inflation continues to decline—or a hard landing—if output and employment begin to fall as the economy enters a recession.  Although a consensus seems to be building among economists, policymakers, and Wall Street analysts that a soft landing is the likeliest outcome, Powell has provided a reminder that that outcome is far from certain.

Fed Governor Christopher Waller Gives an Optimistic Speech

Federal Reserve Governor Christopher J. Waller (photo from the Associated Press via the Wall Street Journal)

Fed Governor Christopher Waller has a reputation for being a policy hawk, which means that since the spring of 2022 he has been a forceful advocate of multiple increases in the target for the federal funds rate as the Fed attempts to slow the economy and bring inflation back to the Fed’s 2 percent target. (Waller’s biography on the Fed’s web site can be found here.)

So, it was notable that in a speech at the American Enterprise Institute (AEI) on November 28, he said that “I am increasingly confident that policy is currently well positioned to slow the economy and get inflation back to 2 percent.” Although he also stressed that “there is still significant uncertainty about the pace of future activity, and so I cannot say for sure whether the [Federal Open Market Committee] FOMC has done enough to achieve price stability” his remarks were interpreted as reinforcing the growing view among non-Fed economists and investors that the FOMC is unlikely to increase its target for the federal funds rate further and is likely to reduce the target at some point during 2024. The text of Waller’s speech can be found here.

AEI economist Michael Strain interviewed Waller following his speech. In the interview (which can be found here), Strain made the case for believing that the Fed’s ability to achieve a soft landing—returning inflation to the 2 percent target without pushing the economy into a recession—would be more difficult than Waller seems to believe. Included in the interview are discussions of whether expecting a soft landing is consistent with the historical record, what guidance the Taylor rule can give to monetary policymakers (we discuss the Taylor rule in Macroeconomics, Chapter 15, Section 15.5, Economics, Chapter 25, Section 15.5, and Essentials of Economics, Chapter 17, Section 17.5), the significance of rising labor force participation rates among prime-age workers, and the implications large federal budget deficits have for monetary policy.

Wall Street Journal: “Cooling Inflation Likely Ends Fed Rate Hikes”

The Bureau of Labor Statistics released its latest report on consumer prices the morning of November 14. The Wall Street Journal’s headline reflects the general reaction to the report: The inflation rate continued to decline, which made it less likely that the Fed’s Federal Open Market Committee will raise its target range for the federal funds rate again at its December meeting. The following figure shows inflation measured as the percentage change in the Consumer Price Index (CPI) from the same month in the previous year. It also shows the inflation rate measure using “core” CPI, which excludes prices for food and energy.

The inflation rate for the CPI declined from 3.7 percent in September to 3.2 percent in October. Core CPI declined from 4.1 percent in September to 4.0 percent in October. So, measured this way, inflation declined substantially when measured by the CPI including prices of all goods and services but only slightly when measured using core CPI.

The 12-month inflation rate is the one typically reported in the Wall Street Journal and elsewhere, but it has the drawback that it doesn’t always reflect accurately the current trend in prices. The following figure shows the 1-month inflation rate—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year— for CPI and core CPI. The 1-month inflation rate is naturally more volatile than the 12-month inflation rate. In this case, 1-month rate shows a sharp decline in the inflation rate for the CPI from 4.9 percent in September to 0.5 percent in October. Core inflation declined less sharply from 3.9 percent in September to 2.8 percent in October.

The release of the CPI report was treated as good news on Wall Street, with the Dow Jones Industrial Average increasing by 500 points and the interest rate on the 10-year U.S. Treasury Note declining from 4.6 percent just before the report was released to 4.4 percent immediately after. The increases in stock and bond prices (recall that the prices of bonds and the yields on the bonds move in opposite directions, so bond prices rose following release of the report) reflect the view of financial investors that if the FOMC stops increasing its target for the federal funds rate, the chance that the U.S. economy will fall into a recession is reduced.

A word of caution, however. In a speech on November 9, Fed Chair Jerome Powell noted that the FOMC may need still need to implement additional increases to its federal funds rate target:

“My colleagues and I are gratified by this progress [against inflation] but expect that the process of getting inflation sustainably down to 2 percent has a long way to go…. The Federal Open Market Committee (FOMC) is committed to achieving a stance of monetary policy that is sufficiently restrictive to bring inflation down to 2 percent over time; we are not confident that we have achieved such a stance. We know that ongoing progress toward our 2 percent goal is not assured: Inflation has given us a few head fakes. If it becomes appropriate to tighten policy further, we will not hesitate to do so.”

So, while the latest inflation report is good news, it’s still too early to know whether inflation is on a stable path to return to the Fed’s 2 percent target. (It’s worth noting that the Fed uses inflation as measured by the personal consumption expenditure (PCE) price index rather than as measured by the CPI when evaluating whether it has achieved its 2 percent target.)

A Review of Recent Macro Data

Some interesting macro data were released during the past two weeks. On the key issues, the data indicate that inflation continues to run in the range of 3.0 percent to 3.5 percent, although depending on which series you focus on, you could conclude that inflation has dropped to a bit below 3 percent or that it is still in vicinity of 4 percent.  On balance, output and employment data seem to be indicating that the economy may be cooling in response to the contractionary monetary policy that the Federal Open Market Committee began implementing in March 2022.

We can summarize the key data releases.

Employment, Unemployment, and Wages

On Friday morning, the Bureau of Labor Statistics (BLS) released its Employment Situation report. (The full report can be found here.) Economists and policymakers—notably including the members of the Federal Reserve’s Federal Open Market Committee (FOMC)—typically focus on the change in total nonfarm payroll employment as recorded in the establishment, or payroll, survey. That number gives what is generally considered to be the best indicator of the current state of the labor market.

The previous month’s report included a surprisingly strong net increase of 336,000 jobs during September. Economists surveyed by the Wall Street Journal last week forecast that the net increase in jobs in October would decline to 170,000. The number came in at 150,000, slightly below that estimate. In addition, the BLS revised down the initial estimates of employment growth in August and September by a 101,000 jobs. The figure below shows the net gain in jobs for each  month of 2023.

Although there are substantial fluctuations, employment increases have slowed in the second half of the year. The average increase in employment from January to June was 256,667. From July to October the average increase declined to 212,000. In the household survey, the unemployment rate ticked up from 3.8 percent in September to 3.9 percent in October. The unemployment rate has now increased by 0.5 percentage points from its low of 3.4 percent in April of this year. 

Finally, data in the employment report provides some evidence of a slowing in wage growth. The following figure shows wage inflation as measured by the percentage increase in average hourly earnings (AHE) from the same month in the previous year. The increase in October was 4.1 percent, continuing a generally downward trend since March 2022, although still somewhat above wage inflation during the pre-2020 period.

As the following figure shows, September growth in average hourly earnings measured as a compound annual growth rate was 2.5 percent, which—if sustained—would be consistent with a rate of price inflation in the range of the Fed’s 2 percent target.  (The figure shows only the months since January 2021 to avoid obscuring the values for recent months by including the very large monthly increases and decreases during 2020.)

Job Openings and Labor Turnover Survey (JOLTS) 

On November 1, the BLS released its Job Openings and Labor Turnover Survey (JOLTS) report for September 2023. (The full report can be found here.) The report indicated that the number of unfilled job openings was 9.5 million, well below the peak of 11.8 million job openings in December 2021 but—as shown in the following figure—well above prepandemic levels.

The following figure shows the ratio of the number of job opening to the number of unemployed people. The figure shows that, after peaking at 2.0 job openings per unemployed person in in March 2022, the ratio has decline to 1.5 job opening per unemployed person in September 2022. While high, that ratio was much closer to the ratio of 1.2 that prevailed during the year before the pandemic. In other words, while the labor market still appears to be strong, it has weakened somewhat in recent months.

Employment Cost Index

As we note in this blog post, the employment cost index (ECI), published quarterly by the BLS, measures the cost to employers per employee hour worked and can be a better measure than AHE of the labor costs employers face. The BLS released its most recent report on October 31. (The report can be found here.) The first figure shows the percentage change in ECI from the same quarter in the previous year. The second figure shows the compound annual growth rate of the ECI. Both measures show a general downward trend in the growth of labor costs, although compound annual rate of change shows an uptick in the third quarter of 2023. (We look at wages and salaries rather than total compensation because non-wage and salary compensation can be subject to fluctuations unrelated to underlying trends in labor costs.)

The Federal Open Market Committee’s October 31-November 1 Meeting

As was widely expected from indications in recent statements by committee members, the Federal Open Market Committee voted at its most recent meeting to hold constant its targe range for the federal funds rate at 5.25 percent to 5.50 percent. (The FOMC’s statement can be found here.)

At a press conference following the meeting, Fed Chair Jerome Powell remarks made it seem unlikely that the FOMC would raise its target for the federal funds rate at its December 14-15 meeting—the last meeting of 2023. But Powell also noted that the committee was unlikely to reduce its target for the federal funds rate in the near future (as some economists and financial jounalists had speculated): “The fact is the Committee is not thinking about rate cuts right now at all. We’re not talking about rate cuts, we’re still very focused on the first question, which is: have we achieved a stance of monetary policy that’s sufficiently restrictive to bring inflation down to 2 percent over time, sustainably?” (The transcript of Powell’s press conference can be found here.)

Investors in the bond market reacted to Powell’s press conference by pushing down the interest rate on the 10-year Treasury note, as shown in the following figure. (Note that the figure gives daily values with the gaps representing days on which the bond market was closed) The interest rate on the Treasury note reflects investors expectations of future short-term interest rates (as well as other factors). Investors interpreted Powell’s remarks as indicating that short-term rates may be somewhat lower than they had previously expected.

Real GDP and the Atlanta Fed’s Real GDPNow Estimate for the Fourth Quarter

On October 26, the Bureau of Economic Analysis (BEA) released its advance estimate of real GDP for the third quarter of 2023. (The full report can be found here.) We discussed the report in this recent blog post. Although, as we note in that post, the estimated increase in real GDP of 4.9 percent is quite strong, there are indications that real GDP may be growing significantly more slowly during the current (fourth) quarter.

The Federal Reserve Bank of Atlanta compiles a forecast of real GDP called GDPNow. The GDPNow forecast uses data that are released monthly on 13 components of GDP. This method allows economists at the Atlanta Fed to issue forecasts of real GDP well in advance of the BEA’s estimates. On November 1, the GDPNow forecast was that real GDP in the fourth quarter of 2023 would increase at a slow rate of 1.2 percent. If this preliminary estimate proves to be accurate, the growth rate of the U.S. economy will have sharply declined from the third to the fourth quarter.

Fed Chair Powell has indicated that economic growth will likely need to slow if the inflation rate is to fall back to the target rate of 2 percent. The hope, of course, is that contractionary monetary policy doesn’t cause aggregate demand growth to slow to the point that the economy slips into a recession.

Very Strong GDP Report

Photo from Lena Buonanno

This morning the Bureau of Economic Analysis (BEA) released its advance estimate of GDP for the third quarter of 2023. (The report can be found here.) The BEA estimates that real GDP increased by 4.9 percent at an annual rate in the third quarter—July through September. That was more than double the 2.1 percent increase in real GDP in the second quarter, and slightly higher than the 4.7 percent that economists surveyed by the Wall Street Journal last week had expected. The following figure shows the rates of GDP growth each quarter beginning in 2021.

Note that the BEA’s most recent estimates of real GDP during the first two quarters of 2022 still show a decline. The Federal Reserve’s Federal Open Market Committee only switched from a strongly expansionary monetary policy, with a target for the federal funds of effectively zero, to a contractionary monetary policy following its March 16, 2022 meeting. That real GDP was declining even before the Fed had pivoted to a contractionary monetary policy helps explain why, despite strong increases employment during this period, most economists were expecting that the U.S. economy would experience a recession at some point during 2022 or 2023. This expectation was reinforced when inflation soared during the summer of 2022 and it became clear that the FOMC would have to substantially raise its target for the federal funds rate.

Clearly, today’s data on real GDP growth, along with the strong September employment report (which we discuss in this blog post), indicates that the chances of the U.S. economy avoiding a recession in the future have increased and are much better than they seemed at this time last year.

Consumer spending was the largest contributor to third quarter GDP growth. The following figure shows growth rates of real personal consumption expenditures and the subcategories of expenditures on durable goods, nondurable goods, and services. There was strong growth in each component of consumption spending. The 7.6 percent increase in expenditures on durables was particularly strong, particularly given that spending on durables had fallen by 0.3 percent in the second quarter.

Investment spending and its components were a more mixed bag, as shown in the following figure. Overall, gross private domestic investment increased at a very strong rate of 8.4 percent—the highest rate since the fourth quarter of 2021. Residential investment increased 3.9 percent, which was particularly notable following nine consecutive quarters of decline and during a period of soaring mortgage interest rates. But business fixed investment was noticeably weak, falling by 0.1 percent. Spending on structures—such as factories and office buildings—increased by only 1.6 percent, while spending on equipment fell by 3.8 percent.

Today’s real GDP report also contained data on the private consumption expenditure (PCE) price index, which the FOMC uses tp determine whether it is achieving its goal of a 2 percent inflation rate. The following figure shows inflation as measured using the PCE and the core PCE—which excludes food and energy prices—since the beginning of 2015. (Note that these inflation rates are measured using quarterly data and as compound annual rates of change.) Despite the strong growth in real GDP and employment, inflation as measured by PCE increased only from 2.5 percent in the second quarter to 2.9 percent in the third quarter. Core PCE, which may be a better indicator of the likely course of inflation in the future, continued the long decline that began in first quarter of 2022 by failling from 3.7 percent to 2.9 percent.

The combination of strong growth in real GDP and declining inflation indicates that the Fed appears well on its way to a soft landing—achieving  a return to its 2 percent inflation target without pushing the economy into a recession. There are reasons to be cautious, however.

GDP, inflation, and employment data are all subject to—possibly substantial—revisions. So growth may have been significantly slower than today’s advance estimate of real GDP indicates. Even if the estimate of real GDP growth of 4.9 percent proves in the long run to have been accurate, there are reasons to doubt whether output growth can be maintained at near that level. Since 2000, annual growth in real GDP has average only 2.1 percent. For GDP to begin increasing at a rate substantially higher than that would require a significant expansion in the labor force and an increase in productivity. While either or both of those changes may occur, they don’t seem likely as of now.

In addition, the largest contributor to GDP growth in the third quarter was from consumption expenditures. As households continue to draw down the savings they built up as a result of the federal government’s response to the Covid recession of 2020, it seems unlikely that the current pace of consumer spending can be maintained. Finally, the lagged effects of monetary policy—particularly the effects of the interest rate on the 10-year Treasury note having risen to nearly 5 percent (which we discuss in our most recent podcast)—may substantially reduce growth in real GDP and employment in future quarters.

But those points shouldn’t distract from the fact that today’s GDP report was good news for the economy.

10/21/23 Podcast – Authors Glenn Hubbard & Tony O’Brien reflect on the Fed’s efforts to execute the soft-landing.

Join authors Glenn Hubbard & Tony O’Brien as they reflect on the Fed’s efforts to execute the soft landing, ponder if the effect will stick, and wonder if future economies will be tethered to an anchor point above two percent.

Another Mixed Inflation Report

Fed Chair Jerome Powell and Fed Vice-Chair Philip Jefferson this summer at the Fed conference in Jackson Hole, Wyoming. (Photo from the AP via the Washington Post.)

This morning, the Bureau of Labor Statistics (BLS) released its report on the consumer price index (CPI) for September. (The full report can be found here.) The report was consistent with other recent data showing that inflation has declined markedly from its summer 2022 highs, but appears, at least for now, to be stuck in the 3 percent to 4 percent range—well above the Fed’s 2 percent inflation target. 

The report indicated that the CPI rose by 0.4 percent in September, which was down from 0.6 percent in August. Measured by the percentage change from the same month in the previous year, the inflation rate was 3.7 percent, the same as in August. Core CPI, which excludes the prices of food and energy, increased by 4.1 percent in September, down from 4.4 percent in August. The following figure shows inflation since 2015 measured by CPI and core CPI.

Reporters Gabriel Rubin and Nick Timiraos, writing in the Wall Street Journal summarized the prevailing interpretation of this report:

“The latest inflation data highlight the risk that without a further slowdown in the economy, inflation might settle around 3%—well below the alarming rates that prompted a series of rapid Federal Reserve rate increases last year but still above the 2% inflation rate that the central bank has set as its target.”

As we discuss in this blog post, some economists and policymakers have argued that the Fed should now declare victory over the high inflation rates of 2022 and accept a 3 percent inflation rate as consistent with Congress’s mandate that the Fed achieve price stability. It seems unlikely that the Fed will follow that course, however. Fed Chair Jerome Powell ruled it out in a speech in August: “It is the Fed’s job to bring inflation down to our 2 percent goal, and we will do so.”

To achieve its goal of bringing inflation back to its 2 percent targer, it seems likely that economic growth in the United States will have to slow, thereby reducing upward pressure on wages and prices. Will this slowing require another increase in the Federal Open Market Committe’s target range for the federal funds rate, which is currently 5.25 to 5.50 percent? The following figure shows changes in the upper bound for the FOMC’s target range since 2015.

Several members of the FOMC have raised the possibility that financial markets may have already effectively achieved the same degree of policy tightening that would result from raising the target for the federal funds rate. The interest rate on the 10-year Treasury note has been steadily increasing as shown in the following figure. The 10-year Treasury note plays an important role in the financial system, influencing interest rates on mortgages and corporate bonds. In fact, the main way in which monetary policy works is for the FOMC’s increases or decreases in its target for the federal funds rate to result in increases or decreases in long-run interest rates. Higher long-run interest rates typically result in a decline in spending by consumrs on new housing and by businesses on new equipment, factories computers, and software.

Federal Reserve Bank of Dallas President Lorie Logan, who serves on the FOMC, noted in a speech that “If long-term interest rates remain elevated … there may be less need to raise the fed funds rate.” Similarly, Fed Vice-Chair Philip Jefferson stated in a speech that: “I will remain cognizant of the tightening in financial conditions through higher bond yields and will keep that in mind as I assess the future path of policy.”

The FOMC has two more meetings scheduled for 2023: One on October 31-November 1 and one on December 12-13. The following figure from the web site of the Federal Reserve Bank of Atlanta shows financial market expectations of the FOMC’s target range for the federal funds rate in December. According to this estimate, financial markets assign a 35 percent probability to the FOMC raising its target for the federal funds rate by 0.25 or more. Following the release of the CPI report, that probability declined from about 38 percent. That change reflects the general expectation that the report didn’t substantially affect the likelihood of the FOMC raising its target for the federal funds rate again by the end of the year.

Surprisingly Strong Jobs Report

Photo from Lena Buonanno

When the Bureau of Labor Statistics’ Employment Situation report is released on the first Friday of each month economists and policymakers—notably including the members of the Federal Reserve’s Federal Open Market Committee (FOMC)—focus on the change in total nonfarm payroll employment as recorded in the establishment, or payroll, survey. That number gives what is generally considered to be the best indicator of the current state of the labor market. The most recent report showed a surprisingly strong net increase of 336,000 jobs during September. (The report can be found here.)

According to a survey by the Wall Street Journal, economists had been expecting an net increase in jobs of only 170,000. The larger than expected increase indicated that the economy might be expanding more rapidly than had been thought, raising the possibility that the FOMC might increase its target for the federal funds rate at least once more before the end of the year.

To meet increases in the growth of the U.S. working-age population, the economy needs to increase the total jobs available by approximately 80,000 jobs per month. A net increase of more than four times that amount may be an indication of an overheated job market. As always, one difficulty with drawing that conclusion is determing how many more people might be pulled into the labor market by a strong demand for workers. An increase in labor supply can potentially satisify an increase in labor demand without leading to an acceleration in wage growth and price inflation.

The following figure shows the employment-to-population ratio for workers ages 25 to 54—so-called prime-age workers—for the period since 1985. In September 2023, the ratio was 80.8 perccent, down slightly from 80.9 percent in August, but above the levels reached in early 2020 just before the effects of the Covid–19 pandemic were felt in the United States. The ratio was still below the record high of 81.9 percent reached in April 2000. The population of prime-age workers is about 128 million. So, if the employment-population ratio were to return to its 2000 peak, potentially another 1.3 million prime-age workers might enter the labor market. The likelihood of that happening, however, is difficult to gauge.

A couple of other points about the September employment report. First, it’s worth keeping in mind that the results from the establishment survey are subject to often substantial revisisons. The figure below shows the revisions the BLS has released as of October to their preliminary estimates for each month of 2023. In three of these eight months the revisions so far have been greater than 100,000 jobs. As we discuss in Macroeconomics, Chapter 9, Section 9.1 (Economics, Chapter 19, Section 19.1 and Essentials of Economics, Chapter 13, Section 13.1), the revisions that the BLS makes to its employment estimates are likely to be particularly large when the economy is about to enter a period of significantly lower or higher growth. So, the large revisions to the preliminary employment estimates in most months of 2023 may indicate that the surprisingly large preliminary estimate of a 336,000 increase in net employment will be revised lower in coming months.

Finally, data in the employment report provides some evidence of a slowing in wage growth, despite the sharp increase in employment. The following figure shows wage inflation as measured by the percentage increase in average hourly earnings (AHE) from the same month in the previous year. The increase in September was 4.2 percent, continuing a generally downward trend since March 2022, although still somewhat above wage inflation during the pre-2020 period.

As the following figure shows, September growth in average hourly earnings measured as a compound annual growth rate was 2.5 percent, which—if sustained—would be consistent with a rate of price inflation in the range of the Fed’s 2 percent target.  (The figure shows only the months since January 2021 to avoid obscuring the values for recent months by including the very large monthly increases and decrease during 2020.)

As we note in this blog post, the employment cost index (ECI), published quarterly by the BLS, measures the cost to employers per employee hour worked and can be a better measure than AHE of the labor costs employers face. The first figure shows the percentage change in ECI from the same quarter in the previous year. The second figure shows the compound annual growth rate of the ECI. Both measures show a general downward trend in the growth of labor costs, although the measures are somewhat dated because the most recent values are for the second quarter of 2023.

Ultimately, the key question is one we’ve considered in previous blog posts (most recently here) and podcasts (most recently here): Will the Fed be able to achieve a soft landing by bringing inflation down to its 2 percent target without triggering a recession? The September jobs report can be interpreted as increasing the probability of a soft landing if the slowing in wage growth is emphasized but decreasing the probability if the Fed decides that the strong employment growth is real—that is, the September increase is not likely to be revised sharply lower in coming months—and requires additional increases in the target for the federal funds rate. It’s worth mentioning, of course, that factors over which the Fed has no control, such as a federal government shutdown, rising oil prices, or uncertainty resulting from the attack on Israel by Hamas, will also affect the likelihood of a soft landing.

The Fed Throws Wall Street a Curveball

A trader on the New York Stock Exchange listtening to Fed Chair Jerome Powell (from Reuters via the New York Times)

Accounting for movements in the market prices of stocks and bonds is not an exact exercise. Accounts in the Wall Street Journal and on other business web sites often attribute movements in stock and bond prices to the Fed having acted in a way that investors didn’t expect. 

The decision by the Fed’s Federal Open Market Committee (FOMC) at its meeting on September 20-21, 2023 to hold its target for the federal funds rate constant at a range of 5.25 percent to 5.50 percent wasn’t a surprise. Fed Chair Jerome Powell had signaled during his press conference on July 26 following the FOMC’s previous meeting that the FOMC was likely to pause further increases in the federal funds rate target. (A transcript of Powell’s July 26 press conference can be found here.)

In advance of the September meeting, some other members of the FOMC had also signaled that the committee was unlikely to increase its target. For instance, an article in the Wall Street Journal quoted Susan Collins, president of the Federal Reserve Bank of Boston, as stating that: “The risk of inflation staying higher for longer must now be weighed against the risk that an overly restrictive stance of monetary policy will lead to a greater slowdown than is needed to restore price stability.” And in a speech in August, Raphael Bostic, president of the Federal Reserve Bank of Atlanta, explained his position on future rate increases: “Based on current dynamics in the macroeconomy, I feel policy is appropriately restrictive. I think we should be cautious and patient and let the restrictive policy continue to influence the economy, lest we risk tightening too much and inflicting unnecessary economic pain.”

Although it wasn’t a surprise that the FOMCdecided to hold its target for the federal funds rate constant, after the decision was announced, stock and bond prices declined. The following figure shows the S&P 500 index of stock prices. The index declined 2.8 percent from September 19—the day before the FOMC meeting—to September 22—two days after the meeting. (We discuss indexes of stock prices in Macroeconomics, Chapter 6, Section 6.2; Economics, Chapter 8, Section 8.2; and Essentials of Economics, Chapter 8, Section 8.2.)

We see a similar pattern in the bond market. Recall that when the price of bonds declines in the bond market, the interest rates—or yields—on the bonds increase. As the following figure shows, the interest rate on the 10-year Treasury note rose from 4.37 percent on September 19 to 4.49 percent on September 21. The 10-year Treasury note plays an important role in the financial system, influencing interest rates on mortgages and corporate bonds. So, the yield on the 10-year Treasury note increasing from 3.3 percent in the spring of 2023 to 4.5 percent following the FOMC meeting has the effect of increasing long-term interest rates throughout the U.S. economy.

What explains the movements in the prices of stocks and bonds following the September FOMC meeting? Investors seem to have been surprised by: 1) what Chair Powell had to say in his news conference following the meeting; and 2) the committee members’ Summary of Economic Projections (SEP), which was released after the meeting.

Powell’s remarks were interpreted as indicating that the FOMC was likely to increase its target for the federal funds rate at least once more in 2023 and was unlikely to cut its target before late 2024. For instance, in response to a question Powell said: “We need policy to be restrictive so that we can get inflation down to target. Okay. And we’re going to need that to remain to be the case for some time.” Investors often disagree in their interpretations of what a Fed chair says. Fed chairs don’t act unilaterally because the 12 voting members of the FOMC decide on the target for the federal funds rate. So chairs tend to speak cautiously about future policy. Still, their seemed to be a consensus among investors that Powell was indicating that Fed policy would be more restrictive (or contractionary) than had been anticipated prior to the meeting.

The FOMC releases the SEP four times per year. The most recent SEP before the September meeting was from the June meeting. The table below shows the median of the projections, or forecasts, of key economic variables made by the members of the FOMC at the June meeting. Note the second row from the bottom, which shows members’ median forecast of the federal funds rate.

The following table shows the median values of members’ forecast at the September meeting. Look again at the next to last row. The members’ forecast of the federal funds rate at the end of 2023 was unchanged. But their forecasts for the federal funds rate at the end of 2024 and 2025 were both 0.50 percent higher.

Why were members of the FOMC signaling that they expected to hold their target for the federal funds rate higher for a longer period? The other economic projections in the tables provide a clue. In September, the members expected that real GDP growth would be higher and the unemployment rate would be lower than they had expected in June. Stronger economic growth and a tighter labor market seemed likely to require them to maintain a contractionary monetary policy for a longer period if the inflation rate was to return to their 2.0 percent target. Note that the members didn’t expect that the inflation rate would return to their target until 2026.