July FOMC Meeting Preview: It's Good to Wait
With underlying inflation trends still above 2% and Fed officials noting uneven progress, they’ll hold steady this meeting, making a September cut more likely.
While recent data on CPI inflation and the unemployment rate caused many commentators and market analysts to claim the time is ripe for a rate cut in July, public remarks by Fed officials noted that while there has been inflation progress it was rather uneven in nature. With only moderate slowing of PCE inflation and still strong consumption spending, the FOMC will likely again stand pat at its July meeting, emphasizing more data is needed to assess inflation developments.
Key takeaways:
Underlying PCE inflation trends remained relatively stable in June at above-target levels, at around 2.8% PCE inflation.
As labor market activity has cooled, household wage income growth appears to have slowed recently to a pace that could over time push spending in line with 2% inflation. Real household spending, however, is still growing a strong pace.
As the expected year-ahead real interest rate path remains restrictive and real economic activity levels remain strong, the FOMC will continue to be patient and wait for sustained weakening in inflation data before deciding to cut policy rates.
I thus expect the FOMC to again decide to keep the Fed funds target rate unchanged at 5.25%-5.50%.
The statement following the rate decision will signal a bias to lower rates at some point in the near future, but it will also emphasize uncertainty regarding the timing of this easing that will depend on the incoming data. I don’t expect the phrase “elevated inflation” to be dropped from the statement just yet.
Trends in underlying inflation suggest Fed funds rate cuts could start at the September FOMC meeting. This is my modal expectation, but there’s a notable tail risk that the Fed will again not move in September.
Conditional on a continued slow rate of progress in PCE inflation trends and solid real activity with a cooling but not deteriorating labor market, the Fed will only gradually be cutting rates beyond September with a total of 1-to-2 cuts in 2024.
Back on Track?
The June CPI report released earlier this month built on the May CPI report in that it was another piece of positive news on inflation over the month. Headline CPI was down 0.1% over the month in June whereas core CPI inflation was +0.1% m/m (two-digits: +0.06%).
Some commentators have downplayed the Q1 strength in inflation, relating it to residual seasonality in some elements of the CPI. Of course, based on that reasoning one should also downplay some of the recent weakness in inflation, as it would entail some payback for Q1 residual seasonality. The Cleveland Fed Median and 16% Trimmed Mean CPI measures provide a good cross check for this, as these cast away excess volatile elements, and these slowed a lot less in June at +0.2% month/month for both. Nonetheless, month/month Median and 16% Trimmed Mean CPI inflation rates were up within the 0.1% - 0.25% range for both May and June, and we have not seen this since late 2020, early 2021.
Averaged over six months these underlying CPI inflation series were still overshooting the Fed's 2% inflation target (chart above). One can use the strong correlations between these underlying CPI inflation measures and their PCE equivalents in a state space dynamic factor model to get statistical nowcasts of Median and Trimmed Mean PCE inflation. And at the time of the June CPI report the nowcasted trimmed mean PCE inflation rates approached 2.5%-2.6% on a six-month average basis (diamonds in the chart above), closing on where they’d been at the end of 2023.
While the June Personal Income & Outlays report showed some easing in PCE inflation rates, this easing was more moderate compared to the June CPI report. Indeed, core goods and non-housing core services PCE inflation rates went up over the month. The above discussed expected easing of underlying PCE inflation rates, based on June realizations of their CPI equivalents did not bear out: instead of easing towards a six-month average 2.5% in June, trimmed mean PCE inflation rates remained relatively stable around 2.8% (chart above). Upward revisions to PCE price data in April and May played a role in this lack of progress, underscoring what prominent Fed officials, such as Chair Powell and Governor Waller, have described as “inflation data coming in uneven”.
And while three-month averages suggest that most trimmed mean PCE inflation rates have moved closer to the Fed’s inflation target, the discussion in the previous paragraph suggests this has not been enough to fully erase the effects of the lack of inflation progress earlier in the year. With underlying inflation rates remaining stuck at above-inflation target levels, it could impact inflation expectations. Indeed, when I extract the common trend across a variety of firm and household surveys of near-term inflation expectations for June and July (including the July Atlanta Fed BIE and University of Michigan surveys published earlier this month), it is clear that expectations troughed in Q1 and then moved higher (chart above). This could adversely impact the inflation-adjusted restrictiveness of the Fed’s interest rate policy, making it potentially harder for the Fed to slowdown activity to achieve 2% inflation over time.
The June jobs report showed an unemployment rate that continued to drift up to 4.1% in June. Most of this labor market cooling occurred as the job finding rate of unemployed people declined over the past six months, as firms’ hiring rates moderated and job openings declined. Combining this with a relatively low and stable likelihood that employed persons are separated from their jobs (job separation rate) results in a flow-implied “shadow” unemployment rate that increased ahead of and more notably than the official unemployment (blue vs. orange line in the chart above).
Whether the recent cooling of the labor market is a prelude to the economy slipping into a recession or simply the labor market becoming more balanced is unclear. The Fed certainly seems to be convinced that is the latter:
“One indication that this is a loosening, rather than a weakening, of the labor market is that layoff rates have been more or less steady at the low rate of around 1 percent. To me, this is all evidence of labor supply and demand in balance. […] Back in 2022, I wrote a research note with Fed economist Andrew Figura on the Beveridge curve, which is the relationship between unemployment and the job vacancy rate. In that research, we projected that, if layoffs were steady, the unemployment rate would rise to around 4.5 percent if the job vacancy rate dropped back to its pre-pandemic level of 4.6 percent. The latest data estimated the vacancy rate in May as 4.9 percent, pretty close to the pre-pandemic level.”
Waller, C. J., “Getting Closer”, July 17, 2024.
One way to look at this more quantitatively is to approximate that level of the unemployment rate at which the unemployment and job vacancy rates are equal on the Beveridge Curve. Michaillat and Saez (2024) show that this rate can be easily approximated by a geometric average of the unemployment and job vacancy rates. The gray line in the chart above shows that on a three-month average basis this ‘balanced labor market” unemployment rate declined from about 5.3% in January 2022 to about 4.3% in May 2023 - not too far from the 4.1% and 3.9% flow-consistent and headline three-month average unemployment rates in that month. Therefore, it currently seems indeed more likely that the labor market is cooling owing to a rebalancing of demand and supply rather than a forthcoming recession. This would also be more in line with the still solid levels of economic activity we are observing due to still strong consumption spending.
The drift up in the unemployment rate over the past six months could explain why over that same period total wage income growth of households eased to a pace that is more in line with 2% PCE inflation over the medium term (chart above), despite hourly wage growth still remaining above the inflation target-implied pace. At least based on the current vintage of data, nominal household wage income growth appears to have slowed enough to, eventually, rein in spending towards a pace that would ease inflation back towards the Fed’s inflation target.
How Restrictive Are Real Rates?
To gauge how restrictive the Fed’s interest rate policy is I published back in August 2023 an analysis that focused on a one-year survey-based real interest rate. This rate is calculated by taking the monthly average of daily one-year interest rates and subtracting the (monthly) common inflation expectations factor from the chart above that is scaled in year-on-year PCE inflation terms.
Key to assessing the restrictiveness of these one-year real rates is where neutral real rates are heading. The chart above is an update of an earlier chart and shows that after close to a decade of ultra-low neutral real rates, these rates have trended up since 2016. Since the fall these R* estimates plateaued with the average across the proxies sitting at around 1.4% at this point in July, above the 0.6% rate as implied by the Fed’s June SEP.
The perceived policy stance as depicted by the survey-based one-year real rate in the chart above only became significantly restrictive (by rising beyond the majority of approximate neutral real rate levels) by the summer of 2023. Since then, even as “Main Street” inflation expectations increased in Q2 relative to Q1, the expected restrictiveness of the Fed’s policy stance edged up in Q2 as more rate cuts were priced out of the market rates. With Fed officials recently more explicitly signaling that rate cuts are on the horizon, resulting nominal rate declines have started to temper the restrictiveness of the Fed’s perceived policy stance in July.
What to Expect
While recent inflation data has been encouraging for the Fed, data on especially PCE inflation rates does suggest the path back to the inflation target will be long and full of potholes. Indeed, Fed officials have been consistent in wanting to see “a couple of months” (Waller) of further inflation data and evidence of "[...] months, and more likely quarters [...]" of inflation progress (Musalem). Back in December 2023 when the Fed officially ended the hiking cycle, there was a lot of satisfaction amongst FOMC members of where inflation was at that time: six-month average trimmed mean PCE inflation rates for December equaled 2.5% or less.
With Fed officials keen to see through temporary volatile price components given the many ‘false positives’ over the past year, I interpreted the Fed’s recent desire of evidence of sustained inflation progress over “months, and more likely quarters” as six-month average trimmed PCE inflation rates moving back to where they were back in December, 2.5% or less. And currently, the PCE data does not signal such sustained evidence of inflation progress.
A policy rate cut therefore will not happen at the FOMC meeting this week. It makes sense for Fed officials to further gauge the inflation data that’ll be released between the July and September FOMC meetings, while the labor market is likely rebalancing and not deteriorating. It is conceivable that this will provide enough evidence of sustained inflation progress that we’ll get a rate cut at the September FOMC meeting. I consider this the likely outcome but given the still stubbornly elevated underlying inflation trend that became apparent in last Friday’s June Personal Income & Outlays report there’s a notable tail risk that the Fed will also stand pat at its September meeting.
On the other hand, the Fed has clearly also become more sensitive to the risk that restrictive real rates could lead to labor market cooling morphing into a labor market deterioration. Hence the recently more explicit signaling from Fed officials like Governor Waller that we are closing on the start of rate cuts. I therefore expect the following sentence in the post-July FOMC meeting statement to be revised approximately like this:
“The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence once incoming data confirm that inflation is moving sustainably toward 2 percent.”
This more positive rewording clearly signals the moment of policy easing is nearer without explicitly committing that it will definitely happen at the next meeting. Nominal rate repricing based on the expectational effect of such rewording likely will cause the perceived real policy stance to recede further, as it did earlier this month.
However, given the slow progress in especially the recent PCE inflation data I do not expect the sentence “Inflation has eased over the past year but remains elevated.” to change in the post-meeting statement.
Labor market cooling probably means that dialing down the Fed’s policy restrictiveness is appropriate. But the likely bumpy road towards inflation progress (especially for PCE data), still elevated “Main Street” inflation expectations and strong consumption spending driving above-trend economic growth means that rate cuts that are forthcoming in the near-term will aim for a “less restrictive stance” rather than “a timely return to neutral”. As such I expect 1-to-2 rate cuts this year.
To recap, Wednesday I expect to see and get evidence of:
No change in the Fed funds target range.
A more positive rewording in the post-meeting statement that policy easing is appropriate at some point in the near future. But I do not expect “elevated inflation” to disappear from the statement just yet.
A likely, but not entirely certain, rate cut at the September FOMC meeting and 1-to-2 rate cuts in total for 2024.