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Financial Markets Correctly Forecast Today’s 0.50% Cut in the Federal Funds Rate Target

Federal Reserve Chair Jerome Powell (Photo from federalreserve.gov)

In a blog post yesterday (September 17), we noted that trading on the CME’s federal funds futures market indicated that investors assigned a probability of 63 percent to the Federal Open Market Committee (FOMC) announcing today a 0.50 percentage point (50 basis points) cut to its target range for the federal funds rate and a probability of 37 percent to a 0.25 percentage point (25 basis points) cut. (100 basis points equals 1 percentage point.) The forecast proved correct when the FOMC announced this afternoon that it was cutting its target range to 4.75 percent to 5.00 percent, from the range of 5.25 percent to 5.50 percent that had been in place since July 2023.

Congress has given the Fed a dual mandate to achieve maximum employment and price stability. In March 2022, the FOMC began responding to the surge in inflation that had begun in the spring of 2021 by raising its target for the federal funds rate. Up through its July 2024 meeting, the FOMC had been focused on the risk that the inflation rate would remain above the Fed’s target inflation rate of 2 percent. In the statement released after today’s meeting, the committee stated that it “has gained greater confidence that inflation is moving sustainably toward 2 percent, and judges that the risks to achieving its employment and inflation goals are roughly in balance.”

In a press conference following the meeting, Fed Chair Jerome Powell indicated that with inflation close to the 2 percent target and the labor market continuing to cool “by any measure,” the committee judged that it was time to begin normalizing its target range for the federal funds rate. Powell said that: “The U.S. economy is in a good place and our action is intended to keep it there.” When asked by a reporter whether the committee cut its target by 50 basis points today to catch up for not having cut its target at its July meeting, Powell responded that: “We don’t think we’re behind [on cutting the target range]. We think this [50 basis point cut] will keep us from falling behind.”

At the conclusion of each meeting, the committee holds a formal vote on its target for the federal funds rate. The vote today was 15-1, with Governor Michelle Bowman casting the sole negative vote. She stated that she would have preferred a 25 basis point cut. Dissenting votes have been rare in recent years.

How much lower will the federal funds target range go? Typically at the FOMC’s December, March, June, and September meetings, the committee releases a “Summary of Economic Projections” (SEP), which presents median values of the committee members’ forecasts of key economic variables. The following table is from the SEP released after today’s meeting.

Looking at the values under the heading “Median” on the left side of the table, the median projection for the federal funds rate at the end of the 2024 is 4.4 percent. That projection signals that the committee will likely cut its target range by 25 basis points at each of its two remaining meetings on November 6-7 and December 17-18. The median projection for the federal funds rate at the end of 2025 is 3.4 percent, implying four additional 25 basis points cuts. In the long run, the median projection of the committee is that the federal funds rate will be 2.9 percent, which is somewhat higher than the 2.5 percent rate that the committee had projected at its December 2019 meeting before the start of the Covid pandemic.

Committee members project that the unemployment rate will end the year at 4.4 percent, up from the 4.2 percent rate in August. They expect that the unemployment rate will be 4.2 percent in the long run. The long run unemployment rate is ofter referred to as the natural rate of unemployment. (We discuss the natural rate of unemployment in Macroeconomics, Chapter 9, Section 9.2 and Economics, Chapter 19, Section 19.2.)

The median projection of the committe members is that at the end of 2024 the inflation rate, as measured by the percentage change in the personal consumption expenditures (PCE) price index, will be 2.3 percent, slightly above the Fed’s target rate. Inflation will also run slightly above the Fed’s target in 2025 at 2.1 percent before retuning to 2 percent by the end of 2026. The median projections of the inflation rate at the ends of 2024 and 2025 are lower than the median projections in the SEP that was released after the FOMC meeting on June 11-12.

Did the Federal Funds Futures Market Accurately Forecast the Size of the Rate Cut?

Image generated by GTP-4o “illustrating interest rates.”

Tomorrow (September 18) at 2 p.m. EDT, the Federal Reserve’s policy-making Federal Open Market Committee (FOMC) will announce its target for the federal funds rate. It’s been clear since Fed Chair Jerome Powell’s speech on August 23 at the Kansas City Fed’s annual monetary policy symposium held in Jackson Hole, Wyoming that the FOMC would cut its target for the federal funds rate at its meeting on September 17-18. (We discuss Powell’s speech in this blog post.)

The only suspense has been over the size of the cut. Traditionally, the FOMC has raised or lowered its target for the federal funds rate in 0.25% (or 25 basis points) increments. Occasionally, however, either because economic conditions are changing rapidly or because the committee concludes that it has been adjusting its target too slowly (“fallen behind the curve” is the usual way of putting it) the committee makes 0.50% (50 basis points) changes to its target.

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 figure summarizes the implied probabilities from federal funds rate futures trading of the FOMC cutting its target by 25 basis points (the orange bars) or 50 basis points (the blue bars) at tomorrow’s meeting. The probabilities on four days are shown—today, yesterday, one week ago, and one month ago.

The figure shows how sentiment among investors has changed over the past month. On August 16, investors assigned a 75 percent probability of a 25 basis point cut in the target range and only a 25 percent probability of a 50 basis point cut. Yesterday and today, investor sentiment has swung sharply toward expecting a 50 basis point cut. Why the shift? As the Fed attempts to fulfill its dual mandate of maximum employment and price stability, it’s focus since the spring of 2022 had been on bringing inflation back down to its 2 perecent target. But as the unemployment rate has slowly risen, output growth has cooled, and more consumers are delinquent on their auto loan and credit card payments, some members of the committee now believe that the committee made a mistake in not cutting the target range by 25 basis points at its last meeting at the end of July. For these members, a 50 basis point cut tomorrow would bring the changes in the target range back on track.

How well did investors in the federal funds futures market forecast the FOMC’s decision? If you are reading this after 2 p.m. EDT on September 18, you’ll know the answer.

Mixed CPI Inflation Report Sets the Stage for Fed Rate Cut

Image illustrating inflation generated by GTP-4o.

Today (September 11), the Bureau of Labor Statistics (BLS) released its monthly report on the consumer price index (CPI). This report is the last one that will be released before the Fed’s policy-making Federal Open Market Committee (FOMC) holds its next meeting on September 17-18.

As the following figure shows, the inflation rate for August measured by the percentage change in the CPI from the same month in the previous month—headline inflation (the blue line)—was 2.6 percent down from 2.9 percent in July. Core inflation (the red line)—which excludes the prices of food and energy—increased slightly to 3.3 percent in August from 3.2 percent in July. Headline inflation was slightly below what economists surveyed by the Wall Street Journal had expected, while core inflation was slightly higher.

As the following figure shows, if we look at the 1-month inflation rate for headline and core inflation—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year—we see that both headline and core inflation increased. Headline inflation (the blue line) increased from 1.8 percent in July to 2.3 percent in August. Core inflation (the red line) jumped from 2.0 percent in July to 3.4 percent in August. Overall, we can say that, taking 1-month and 12 month inflation together, the U.S. economy may still be on course for a soft landing—with the annual inflation rate returning to the Fed’s 2 percent target without the economy being pushed into a recession—but the increase in 1-month inflation is concerning. Of course, as always, it’s important not to overinterpret the data from a single month. (Note, also, that the Fed uses the personal consumption expenditures (PCE) price index, rather than the CPI in evaluating whether it is hitting its 2 percent inflation target.)

As we’ve discussed in previous blog posts, Federal Reserve Chair Jerome Powell and his colleagues on the FOMC have been closely following inflation in the price of shelter. The price of “shelter” in the CPI, as explained here, includes both rent paid for an apartment or house and “owners’ equivalent rent of residences (OER),” which is an estimate of what a house (or apartment) would rent for if the owner were renting it out. OER is included to account for the value of the services an owner receives from living in an apartment or house.

As the following figure shows, inflation in the price of shelter has been a significant contributor to headline inflation. The blue line shows 12-month inflation in shelter and the red line shows 1-month inflation in shelter. Twelve-month inflation in shelter reversed the decline that began in the spring of 2023, rising from 5.0 percent in July to 5.2 percent August. One-month inflation in shelter—which is much more volatile than 12-month inflation in shelter—increased from 4.6 percent in July to 5.2 percent in August, continuing an increase that began in June. The increase in 1-month inflation in shelter may concern the members of the FOMC, as may, to a lesser extent, the increase in 12-month inflation in shelter. Shelter has a smaller weight of 15 percent in the PCE price index that the Fed uses to gauge whether it is hitting its 2 percent inflation target in contrast with the 33 percent weight that shelter has in the CPI. But persistent shelter inflation in the 5 percent range would make a soft landing more difficult.

Finally, in order to get a better estimate of the underlying trend in inflation, some economists look at median inflation and trimmed mean inflation. Median inflation is calculated by economists at the Federal Reserve Bank of Cleveland and Ohio State University. If we listed the inflation rate in each individual good or service in the CPI, median inflation is the inflation rate of the good or service that is in the middle of the list—that is, the inflation rate in the price of the good or service that has an equal number of higher and lower inflation rates. Trimmed mean inflation drops the 8 percent of good and services with the higherst inflation rates and the 8 percent of goods and services with the lowest inflation rates.

As the following figure (from the Federal Reserve Bank of Cleveland) shows, median inflation (the orange line) declined slightly from 4.3 percent in July to 4.2 percent in August. Trimmed mean inflation (the blue line) also declined slightly from 3.3 in July to 3.2 percent in August. These data provide confirmation that core CPI inflation is likely running higher than a rate that would be consistent with the Fed achieving its inflation target.

For the past few weeks Fed officials have been indicating that the FOMC is likely to cut its target for the federal funds at its next meeting on Septembe 17-18. Investors who buy and sell federal funds futures contracts expect that the FOMC will cut its target for the federal funds rate by 0.25 percentage point from the current range of 5.50 percent to 5.25 percent. (We discuss the futures market for federal funds in this blog post.) As shown in the following figure, today these investors assign a probability of 85.0 percent to the FOMC cutting its target for the federal funds rate by 0.25 percentage point at its next meeting and a probability of only 15.0 percent that the cut will be 0.50 percentage point.

The FOMC has to balance the risk of leaving its target for the federal funds rate at its current level for too long—increasing the risk of slowing demand so much that the economy slips into recession—against the risk of cutting its target too soon—increasing the risk that inflation persists above the Fed’s 2 percent target. We’ll see at the committee’s next meeting how Fed Chair Jerome Powell and the other members assess the current state of the economy as they consider when and by how much to cut their target for the federal funds rate.

Mixed Jobs Report Sets the Stage for the FOMC to Cut Fed Funds Target

Image generated by GTP-4o.

The “Employment Situation” report (often referred to as the “jobs report”), which is released monthly by the Bureau of Labor Statistics (BLS), is always closely followed by economists and policymakers because it provides important insight in the current state of the U.S. economy. This month’s report is considered particularly important because last month’s report indicated that the labor market might be weaker than most economists had believed. As we discussed in a recent blog post, late last month Fed Chair Jerome Powell signaled that the Fed’s policy-making Federal Open Market Committee (FOMC) was likely to cut its target for the federal funds rate at its next meeting on September 17-18.

Economists and investment analysts had speculated that following August’s unexpectedly weak jobs report, another weak report might lead the FOMC to cut its federal funds target by 0.50 percentage rate rather than by the more typical 0.25 percent point. The jobs report the BLS released this morning (September 6) was mixed, showing a somewhat lower than expected increase in employment as measured by the establishment survey, but higher wage growth.

The jobs report has two estimates of the change in employment during the month: one estimate from the establishment survey, often referred to as the payroll survey, and one from the household survey. As we discuss in Macroeconomics, Chapter 9, Section 9.1 (Economics, Chapter 19, Section 19.1), many economists and policymakers at the Federal Reserve believe that employment data from the establishment survey provides a more accurate indicator of the state of the labor market than do either the employment data or the unemployment data from the household survey. (The groups included in the employment estimates from the two surveys are somewhat different, as we discuss in this post.)

According to the establishment survey, there was a net increase of 142,000 jobs during August. This increase was below the increase of 161,000 that economists had forecast in a survey by the Wall Street Journal. The following figure, taken from the BLS report, shows the monthly net changes in employment for each month during the past two years. The BLS revised lower its estimates of the net increase in jobs during June and July by a total of 86,000. (The BLS notes that: “Monthly revisions result from additional reports received from businesses and government agencies since the last published estimates and from the recalculation of seasonal factors.”)

The BLS’s estimate of average monthly job growth during the last three months is now 116,000, a significant decline from an average of 211,000 per month during the previous three months and 251,000 per month during 2023.

As the following figure shows, the net change in jobs from the household survey moves much more erratically than does the net change in jobs in the establishment survey. The net change in jobs as measured by the household survey increased from 67,000 in July to 168,000 in August. So, in this case the direction of change in the two surveys was the same—an increase in the net number of jobs created in August compared with July.

As the following figure shows, the unemployment rate, which is also reported in the household survey, decreased from 4.3 percent to 4.2 percent—breaking what had been a five month string of unemployment rate increases.

The establishment survey also includes data on average hourly earnings (AHE). As we note in this post, many economists and policymakers believe the employment cost index (ECI) is a better measure of wage pressures in the economy than is the AHE. The AHE does have the important advantage that it is available monthly, whereas the ECI is only available quarterly. The following figure shows the percentage change in the AHE from the same month in the previous year. AHE increased 3.8 percent in August, up from a 3.6 percent increase in July.

The following figure shows wage inflation calculated by compounding the current month’s rate over an entire year. (The figure above shows what is sometimes called 12-month wage inflation, whereas this figure shows 1-month wage inflation.) One-month wage inflation is much more volatile than 12-month inflation—note the very large swings in 1-month wage inflation in April and May 2020 during the business closures caused by the Covid pandemic.

The 1-month rate of wage inflation of 4.9 percent in August is a significant increase from the 2.8 percent rate in July, although it’s unclear whether the increase represented renewed upward wage pressure in the labor market or reflected the greater volatility in wage inflation when calculated this way.

What effect is this jobs report likely to have on the FOMC’s actions at its September meeting? One indication comes from investors who buy and sell federal funds futures contracts. (We discuss the futures market for federal funds in this blog post.) As shown in the following figure, today these investors assign a probability of 73.0 percent to the FOMC cutting its target for the federal funds rate by 0.25 percentage point at its next meeting and a probability of only 27.0 percent that the cut will be 0.50 percentage point. In contrast, after the last jobs report was interpreted to indicate a dramatic slowing of the economy, investors assigned a probability of 79.5 percent to a 0.50 cut in the federal funds rate target.

It seems most likely following today’s mixed job report that the FOMC will cut its target for the federal funds rate by 0.25 percent point from the current target range of 5.25 percent to 5.50 percent to a range of 5.00 percent to 5.25 percent. The report doesn’t indicate the significant weakening in the labor market that was probably needed to push the committee to cutting its target by 0.50 percent point.

Unexpectedly Weak Employment Report; Beware the Sahm Rule?

Earlier this week, as we discussed in this blog post, the Federal Reserve’s policy-making Federal Open Market Committee (FOMC) voted to leave its target for the federal funds rate unchanged. In his press conference following the meeting, Fed Chair Jerome Powell stated that: “Overall, a broad set of indicators suggests that conditions in the labor market have returned to about where they stood on the eve of the pandemic—strong but not overheated.”

This morning (August 2), the Bureau of Labor Statistics (BLS) released its “Employment Situation” report (often referred to as the “jobs report”) for July, which indicates that the labor market may be weaker than Powell and the other members of the FOMC believed it to be when they decided to leave their target for the federal funds rate unchanged.

The jobs report has two estimates of the change in employment during the month: one estimate from the establishment survey, often referred to as the payroll survey, and one from the household survey. As we discuss in Macroeconomics, Chapter 9, Section 9.1 (Economics, Chapter 19, Section 19.1), many economists and policymakers at the Federal Reserve believe that employment data from the establishment survey provides a more accurate indicator of the state of the labor market than do either the employment data or the unemployment data from the household survey. (The groups included in the employment estimates from the two surveys are somewhat different, as we discuss in this post.)

According to the establishment survey, there was a net increase of 114,000 jobs during July. This increase was below the increase of 175,000 to 185,000 that economists had forecast in surveys by the Wall Street Journal and bloomberg.com. The following figure, taken from the BLS report, shows the monthly net changes in employment for each month during the past two years.

The previously reported increases in employment for April and May were revised downward by 29,000 jobs. (The BLS notes that: “Monthly revisions result from additional reports received from businesses and government agencies since the last published estimates and from the recalculation of seasonal factors.”) As we’ve discussed in previous posts (most recently here), downward revisions to the payroll employment estimates are particularly likely at the beginning of a recession, although this month’s adjustments were relatively small.

As the following figure shows, the net change in jobs from the household survey moves much more erratically than does the net change in jobs in the establishment survey. The net change in jobs as measured by the household survey declined from 116,000 in June to 67,000 in June. So, in this case the direction of change in the two surveys was the same—a decline in the increase in the number of jobs.

As the following figure shows, the unemployment rate, which is also reported in the household survey, increased from 4.1 percent to 4.3 percent—the highest unemployment rate since October 2021. Although still low by historical standards, July was the fifth consecutive month in which the unemployment rate increased. It is also higher than the unemployment rate just before the pandemic. The unemployment rate was below 4 percent most months from mid-2018 to early 2020.

Some economists and policymakers have been following the Sahm rule, named after Claudia Sahm Chief Economist for New Century Advisors and a former Fed economist. The Sahm rule, as stated on the site of the Federal Reserve Bank of St. Louis is: “Sahm Recession Indicator signals the start of a recession when the three-month moving average of the national unemployment rate (U3 [measure]) rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months.” The following figure shows the values of this indicator dating back to March 1949.

So, according to this indicator, the U.S. economy is now at the start of a recession. Does that mean that a recession has actually started? Not necessarily. As Sahm stated in an interview this morning, her indicator is a historical relationship that may not always hold, particularly given how signficantly the labor market has been affected during the last four years by the pandemic.

As we noted in a post earlier this week, investors who buy and sell federal funds futures contracts assigned a probability of 11 percent that the FOMC would cut its target for the federal funds rate by 0.50 percentage point at its next meeting. (Investors in this market assigned a probability of 89 percent that the FOMC would cut its target by o.25 percentage point.) Today, investors dramatically increased the probability to 79.5 percent of a 0.50 cut in the federal funds rate target, as shown in this figure from the CME site.

Investors on the stock market appear to believe that the probability of a recession beginning before the end of the year has increased, as indicated by sharp declines today in the stock market indexes.

The next scheduled FOMC meeting isn’t until September 17-18. The FOMC is free to meet in between scheduled meetings but doing so might be interpreted as meanng that economy is in crisis, which is a message the committee is unlikely to want to send. It would likely take additional unfavorable reports on macro data for the FOMC not to wait until September to take action on cutting its target for the federal funds rate.

FOMC Holds Rate Target Steady While Hinting at a Cut at the September Meeting

Image of “Federal Reserve Chair Jerome Powell speaking at a podium” generated by GTP-4o.

At the conclusion of its July 30-31 meeting, the Federal Reserve’s policy-making Federal Open Market Committee (FOMC) voted unamiously to leave its target range for the federal funds rate unchanged at 5.25 percent to 5.5 percent. (The statement the FOMC issued following the meeting can be found here.)

In the statement Fed Chair Jerome Powell read at the beginning of his press conference after the meeting, Powell appeared to be repeating a position he has stated in speeches and interviews during the past month:

“We have stated that we do not expect it will be appropriate to reduce the target range for the federal funds rate until we have gained greater confidence that inflation is moving sustainably toward 2 percent. The second-quarter’s inflation readings have added to our confidence, and more good data would further strengthen that confidence. We will continue to make our decisions meeting by meeting.”

But in answering questions from reporters, he made it clear that—as many economists and Wall Street investors had already concluded—the FOMC was likely to reduce its target for the federal funds rate at its next meeting on September 17-18. Powell noted that recent data were consistent with the inflation rate continuing to decline toward the Fed’s 2 percent annual target. Powell summarized the consensus from the discussion among committee members as being that “the time was approaching for cutting rates.”

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 September meeting. The chart indicates that investors assign a probability of 100 percent to the FOMC cutting its federal funds rate target at this meeting. Investors assign a probability of 89.0 percent that the committee will cut its target by 0.25 percentage point and a probability of 11.0 percent that the commitee will cut its target by 0.50 percentage point. When asked at his press conference whether the committee had given any consideration to making a 0.50 percentage point cut in its target, Powell said that it hadn’t.

Powell stated that the latest data on wage increases had led the committee to conclude that the labor market was no longer a source of inflationary pressure. The morning of the press conference, the Bureau of Labor Statistics (BLS) released its latest report on the Employment Cost Index (ECI). As we’ve noted in earlier posts, as a measure of the rate of increase in labor costs, the FOMC prefers the ECI to average hourly earnings (AHE).

As a measure of how wages are increasing or decreasing during a particular period, AHE can suffer from composition effects because AHE data aren’t adjusted for changes in the mix of occupations workers are employed in. In contrast, the ECI holds the mix of occupations constant. The ECI does have the drawback that it is only available quarterly whereas the AHE is available monthly.

The following figure shows the percentage change in the ECI for all civilian workers from the same quarter in the previous year. The blue line looks only at wages and salaries, while the red line is for total compensation, including non-wage benefits like employer contributions to health insurance. The rate of increase in the wage and salary measure decreased slightly from 4.3 percent in the first quarter of 2024 to 4.2 percent in the second quarter of 2024. The rate of increase in compensation also declined slightly from 4.2 percent to 4.1 percent. As the figure shows, both measures continued their declines from the peak of wage inflation during the second quarter of 2022. In his press conference, Powell said that the this latest ECI report was a little better than the committee had expected.

Finally, Powell noted that the committee saw no indication that the U.S. economy was heading for a recession. He observed that: “The labor market has come into better balance and the unemployment rate remains low.” In addition, he said that output continued to grow steadily. In particular, he pointed to growth in real final sales to private domestic purchasers. This macro variable equals the sum of personal consumption expenditures and gross private fixed investment. By excluding exports, government purchases, and changes in inventories, final sales to private domestic purchasers removes the more volatile components of gross domestic product and provides a better measure of the underlying trend in the growth of output.

As the following figure shows, this measure of output has grown at an annual rate of more than 2.5 percent in each of the last three quarters. Output expanding at that rate is indicative of an economy that is neither overheating nor heading toward a recession.

At this point, unless macro data releases are unexpectedly strong or weak during the next six weeks, it seems nearly certain that at its September meeting the FOMC will reduce its target range for the federal funds rate by 0.25 percentage point.

Latest PCE Report Shows Inflation Continues to Ease

Federal Reserve Chair Jerome Powell at a press conference following a meeting of the Federal Open Market Committee (Photo from federal reserve.gov)

Inflation in 2024 is a tale of two quarters. During the first quarter of 2024, inflation ran higher than expected considering the falling inflation rates at the end of 2023. As a result, although at the beginning of the year many economists and Wall Street analysts had expected the Federal Reserve’s policy-making Federal Open Market Committee (FOMC) would cut its target for the federal funds rate at least once in the first half of 2024, the FOMC left its target unchanged.

On July 26, the Bureau of Economic Analysis (BEA) released its “Personal Income and Outlays” report for June. The report includes monthly data on the personal consumption expenditures (PCE) price index. The Fed relies on annual changes in the PCE price index to evaluate whether it’s meeting its 2 percent annual inflation target. The report confirmed that PCE inflation slowed in the second quarter, bringing it closer to the Fed’s 2 percent 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 percentage change in the PCE from the same month in the previous year. Measured this way, in June PCE inflation (the blue line) was 2.5 percent, down slightly from PCE inflation of 2.6 percent in May. Core PCE inflation (the red line) in June was also 2.5 percent, which was unchanged from May.

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 rose in June to 0.9 percent from 0.4 percent in May—although higher in June, inflation was well below the Fed’s 2 percent target in both months. Core PCE inflation rose from 1.5 percent in May to 2.0 percent in June. These data indicate that inflation has been at or below the Fed’s target for the last two months.

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

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. It now seems likely that the FOMC will soon lower the committee’s target for the federal funds rate, which is currently 5.25 percent to 5.50 percent. Remarks by Fed Chair Powell have been interpreted as hinting as much. The next meeting of the FOMC is July 30-31. What do financial markets think the FOMC will decide at that meeting?

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 4.7 percent to the FOMC cutting its federal funds rate target by 0.25 percentage point at its July 30-31 meeting and an 95.3 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 an 87.7 percent probability of a 0.25 percentage point cut and a 11.9 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 effectively assigned a zero probability. In other words, investors believe with near certainty that the FOMC will reduce its target for the federal funds rate for the first time since the current round of rate increases ended in July 2023.

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.

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?

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.

The FOMC Follows the Expected Course in Its Latest Meeting

Chair Jerome Powell at a meeting of the Federal Open Market Committee (photo from federalreserve.gov)

At the beginning of the year, there was an expectation among some economists and policymakers that the Fed’s policy-making Federal Open Market Committee (FOMC) would begin cutting its target range for the federal funds rate at the meeting that ended today (May 1). The Fed appeared to be bringing the U.S. economy in for a soft landing—inflation returning to the Fed’s 2 percent target without a recession occurring.

During the first quarter of 2024, production and employment have been expanding more rapidly than had been expected and inflation has been higher than expected. As a result, the nearly universal expectation prior to this meeting was that the FOMC would leave its target for the federal funds rate unchanged. Some economists and investment analysts have begun discussing the possiblity that the committee might not cut its target at all during 2024. The view that interest rates will be higher for longer than had been expected at the beginning of the year has contributed to increases in long-term interest rates, including the interest rates on the 10-year Treasury Note and on residential mortgage loans.

The statement that the FOMC issued after the meeting confirmed the consensus view:

“Recent indicators suggest that economic activity has continued to expand at a solid pace. Job gains have remained strong, and the unemployment rate has remained low. Inflation has eased over the past year but remains elevated. In recent months, there has been a lack of further progress toward the Committee’s 2 percent inflation objective.”

In his press conference after the meeting, Fed Chair Jerome Powell emphasized that the FOMC was unlikely to cut its target for the federal funds rate until data indicated that the inflation rate had resumed falling towards the Fed’s 2 percent target. At one point in the press conference Powell noted that although it was taking longer than expected for the inflation rate to decline he still expected that the pace of economic actitivity was likely to slow sufficiently to allow the decline to take place. He indicated that—contrary to what some economists and investment analysts had suggested—it was unlikely that the FOMC would raise its target for the federal funds rate at a future meeting. He noted that the possibility of raising the target was not discussed at this meeting.

Was there any news in the FOMC statement or in Powell’s remarks at the press conference? One way to judge whether the outcome of an FOMC meeting is consistent with the expectations of investors in financial markets prior to the meeting is to look at movements in stock prices during the time between the release of the FOMC statement at 2 pm and the conclusion of Powell’s press conference at about 3:15 pm. The following figure from the Wall Street Journal, shows movements in the three most widely followed stock indexes—the Dow Jones Industrial Average, the S&P 500, and the Nasdaq composite. (We discuss movements in stock market indexes in Macroeconomics and Essentials of Economics, Chapter 6, Section 6.2 and in Economics, Chapter 8, Section 8.2.)

If either the FOMC statement or the Powell’s remarks during his press conference had raised the possibility that the committee was considering raising its target for the federal funds rate, stock prices would likely have declined. The decline would reflect investors’ concern that higher interest rates would slow the economy, reducing future corporate profits. If, on the other hand, the statement and Powell’s remarks indicated that the committee would likely cut its target for the federal funds rate relatively soon, stock prices would likely have risen. The figure shows that stock prices began to rise after the 2 pm release of the FOMC statement. Prices rose further as Powell seemed to rule out an increase in the target at a future meeting and expressed confidence that inflation would resume declining toward the 2 percent target. But, as often happens in the market, this sentiment reversed towards the end of Powell’s press conference and two of the three stock indexes ended up lower at the close of trading at 4 pm. Presumably, investors decided that on reflection there was no news in the statement or press conference that would change the consensus on when the FOMC might begin lowering its target for the federal funds rate.

The next signficant release of macroeconomic data will come on Friday when the Bureau of Labor Statistics issues its employment report for April.

Will the Fed Not Cut Rates at All this Year?

Federal Reserve Vice Chair Philip Jefferson (photo from the Federal Reserve)

Federal Reserve Chair Jerome Powell (photo from the Federal Reserve)

At the beginning of 2024, investors were expecting that during the year the Fed’s policy-making Federal Open Market Committee (FOMC) would cut its target range for the federal funds rate six or seven times. At its meeting on March 19-20 the economic projections of the members of the FOMC indicated that they were expecting to cut the target range three times from its current 5.25 percent to 5.50 percent. But, as we noted in this recent post and in this podcast, macroeconomic data during the first three months of this year indicated that the U.S. economy was growing more rapidly than the Fed had expected and the reductions in inflation that occurred during the second half of 2023 had not persisted into the beginning of 2024.

The unexpected strength of the economy and the persistence of inflation above the Fed’s 2 percent target have raised the issue of whether the FOMC will cut its target range for the federal funds rate at all this year. Earlier this month, Neel Kashkari, president of the Federal Reserve Bank of Minneapolis raised the possibility that the FOMC would not cut its target range this year.

Today (April 16) both Fed Vice Chair Philip Jefferson and Fed Chair Jerome Powell addressed the issue of monetary policy. They gave what appeared to be somewhat different signals about the likely path of the federal funds target during the remainder of this year—bearing in mind that Fed officials never commit to any specific policy when making a speech. Adressing the International Research Forum on Monetary Policy, Vice Chair Jefferson stated that:

“My baseline outlook continues to be that inflation will decline further, with the policy rate held steady at its current level, and that the labor market will remain strong, with labor demand and supply continuing to rebalance. Of course, the outlook is still quite uncertain, and if incoming data suggest that inflation is more persistent than I currently expect it to be, it will be appropriate to hold in place the current restrictive stance of policy for longer.”

One interpretation of his point here is that he is still expecting that the FOMC will cut its target for the federal funds rate sometime this year unless inflation remains persistently higher than the Fed’s target—which he doesn’t expect.

Chair Powell, speaking at a panel discussion at the Wilson Center in Washington, D.C., seemed to indicate that he believed it was less likely that the FOMC would reduce its federal funds rate target in the near future. The Wall Street Journal summarized his remarks this way:

“Federal Reserve Chair Jerome Powell said firm inflation during the first quarter had introduced new uncertainty over whether the central bank would be able to lower interest rates this year without signs of an economic slowdown. His remarks indicated a clear shift in the Fed’s outlook following a third consecutive month of stronger-than-anticipated inflation readings ….”

An article on bloomberg.com had a similar interpretation of Powell’s remarks: “Federal Reserve Chair Jerome Powell signaled policymakers will wait longer than previously anticipated to cut interest rates following a series of surprisingly high inflation readings.”

Politics may also play a role in the FOMC’s decisions. As we discuss in Macroeconomics, Chapter 17, Section 17.4 (Economics, Chapter 27, Section 27.4), the Federal Reserve Act, which Congress passed in 1913 and has amended several times since, puts the Federal Reserve in an unusal position in the federal government. Although the members of the Board of Governors are appointed by the president and confirmed by the Senate, the Fed was intended to act independently of Congress and the president. Over the years, Fed Chairs have protected that independence by, for the most part, avoiding taking actions beyond the narrow responsibilites Congress has given to the Fed by Congress and by avoiding actions that could be interpreted as political.

This year is, of course, a presidential election year. The following table from the Fed’s web site lists the FOMC meetings this year. The presidential election will occur on November 5. There are four scheduled FOMC meetings before then. Given that inflation has been running well above the Fed’s target during the first three months of the year, it would likely take at least two months of lower inflation data—or a weakening of the economy as indicated by a rising unemployment rate—before the FOMC would consider lowering its federal funds rate target. If so, the meeting on July 30-31 might be the first meeting at which a rate reduction would occur. If the FOMC doesn’t act at its July meeting, it might be reluctant to cut its target at the September 17-18 meeting because acting close to the election might be interpreted as an attempt to aid President Joe Biden’s reelection.

Although we don’t know whether avoiding the appearance of intervening in politics is an important consideration for the members of the FOMC, some discussion in the business press raises the possibility. For instance, a recent article in the Wall Street Journal noted that:

“The longer that officials wait, the less likely there will be cuts this year, some analysts said. That is because officials will likely resist starting to lower rates in the midst of this year’s presidential election campaign to avoid political entanglements.”

These are clearly not the easiest times to be a Fed policymaker!