Tag: Federal funds rate probabilities

Latest PCE Report Shows Inflation Slowing

Chair Jerome Powell and other members of the Federal Open Market Committee (Photo from federalreserve.gov)

On Friday, June 28, the Bureau of Economic Analysis (BEA) released its “Personal Income and Outlays” report for April, which includes monthly data on the personal consumption expenditures (PCE) price index. Inflation as measured by annual changes in the consumer price index (CPI) receives the most attention in the media, but the Federal Reserve looks instead to inflation as measured by annual changes in the PCE price index to evaluate whether it’s meeting its 2 percent annual inflation target.  

The following figure shows PCE inflation (blue line) and core PCE inflation (red line)—which excludes energy and food prices—for the period since January 2015 with inflation measured as the change in the PCE from the same month in the previous year. Measured this way, in May PCE inflation (the blue line) was 2.6 percent in May, down slightly from PCE inflation of 2.7 percent in April. Core PCE inflation (the red line) in May was also 2.6 percent, down from 2.8 percent in April.

The following figure shows PCE inflation and core PCE inflation calculated by compounding the current month’s rate over an entire year. (The figure above shows what is sometimes called 12-month inflation, while this figure shows 1-month inflation.) Measured this way, PCE inflation sharply declined from 3.2 percent in April to -0.1 percent in in May—meaning that consumer prices actually fell during May. Core PCE inflation declined from 3.2 percent in April to 1.0 percent in May.  This decline indicates that inflation by either meansure slowed substantially in May, but data for a single month should be interpreted with caution.

The following figure shows another way of gauging inflation by including the 12-month inflation rate in the PCE (the same as shown in the figure above—although note that PCE inflation is now the red line rather than the blue line), inflation as measured using only the prices of the services included in the PCE (the green line), and the trimmed mean rate of PCE inflation (the blue line). Fed Chair Jerome Powell and other members of the Federal Open Market Committee (FOMC) have said that they are concerned by the persistence of elevated rates of inflation in services. The trimmed mean measure is compiled by economists at the Federal Reserve Bank of Dallas by dropping from the PCE the goods and services that have the highest and lowest rates of inflation. It can be thought of as another way of looking at core inflation by excluding the prices of goods and services that had particularly high or particularly low rates of inflation during the month.

Inflation using the trimmed mean measure was 2.8 percent in May (calculated as a 12-month inflation rate), down only slightly from 2.9 percent in April—and still well above the Fed’s target inflation rate of 2 percent. Inflation in services remained high in May at 3.9 percent, down only slightly from 4.0 percent in April.

This month’s PCE inflation data indicate that the inflation rate is still declining towards the Fed’s target, with the low 1-month inflation rates being particularly encouraging. But the FOMC will likely need additional data before deciding to lower the committee’s target for the federal funds rate, which is currently 5.25 percent to 5.50 percent. The next meeting of the FOMC is July 30-31. What do financial markets think the FOMC will decide at that meeting?

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 the current values from trading of federal funds futures.

The probabilities in the chart reflect investors’ predictions of what the FOMC’s target for the federal funds rate will be after the committee’s July meeting. The chart indicates that investors assign a probability of only 10.3 percent to the FOMC cutting its federal funds rate target by 0.25 percentage point at that meeting and an 89.7 percent probability of the commitee leaving the target unchanged.

In contrast, the following figure shows that investors expect that the FOMC will cut its federal funds rate at the meeting scheduled for September 17-18. Investors assign a 57.9 percent probability of a 0.25 percentage point cut and a 6.2 percent probability of a 0.50 percentage point cut. The committee deciding to leave the target unchanged at 5.25 percent to 5.50 percent is assigned a probability of only 35.9 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.