June FOMC Meeting: Ready for Take Off?
Inflation trends still run above-2% causing the FOMC to signal only one rate cut for 2024. But recent positive data suggest that a September cut is very likely.
Unsurprisingly, the June FOMC meeting decision did not result in a change in the Fed funds rate target range. The statement confirmed the disappointment with the lack of progress in Q1 inflation data although better inflation data over the intermeeting period was seen as encouraging. During the post-meeting press conference Chair Powell made clear that the Fed funds rate will remain on hold for the foreseeable future until the inflation data shows sustained evidence of disinflation.
Key takeaways:
The FOMC decided to keep the Fed funds target rate unchanged at 5.25%-5.50% and signaled a bias to keep rates on hold for now.
Underlying inflation remains stable at above-target levels, at around 2.8% PCE inflation.
Although the labor market remained relatively strong, household wage income growth has slowed recently to a pace that could over time push spending in line with 2% inflation.
Expected near-term real interest rates remain in line with the Fed’s own assessment of its stance.
As the expected year-ahead real 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.
Trends in underlying inflation suggest Fed funds rate cuts likely will start at the September FOMC meeting. However, conditional on solid real activity AND disagreement in the FOMC regarding the restrictiveness of its policy, the Fed will be very cautious when cutting rates, especially this year.
When Are We Back on Track in Terms of Disinflation?
The Fed has focused for a while on developments in core services excl. housing inflation. The latter component of core inflation is mainly driven by:
Labor costs, as most of the categories in core services excl. housing inflation are labor-intensive in nature.
Consumption expenditures, as the bulk of U.S. consumption spending is traditionally geared towards services spending.
The April Personal Income & Outlays report provided some good news for the Fed in terms of the potential pick up in disinflation going forward. Household wage income growth out of wages and salaries slowed in April and was notably revised down for Q4 2023 and Q1 2024. This meant that household wage income growth slowed to a pace that’s broadly consistent with 2% PCE inflation over the medium-term. (chart above).
Signals from the May jobs report whether we should expect the household wage income moderation to continue were mixed. The May data confirmed that it has become more difficult in H2 2023 and H1 2024 to find a job when unemployed than in 2022, which should solidify the moderation of wage income growth and thus consumption spending over time.
On the other hand, wage data from the May jobs report suggested that April’s pickup in wage inflation was a fluke with wage growth remaining stuck above a 2% inflation pace (chart above). In other words, employed people still have the potential to earn income at solid rates that could keep spending elevated in the near term.
The underlying rates of PCE inflation implied by the April Personal & Outlays report confirmed that progress on disinflation was reversed from December 2023 through March 2024. While positive, the April data represented a sideway move with underlying PCE inflation stuck in the 2.8%-3% range (chart above).
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 April and May (including the May NY Fed SCE survey published earlier this week), it is clear that these expectations troughed in Q1 and then accelerated again (chart above). Not only could this keep wage costs elevated going forward, it also adversely impacts 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 May CPI report released earlier today provided some positive news on inflation over the month. Headline CPI was essentially flat over the month whereas core CPI inflation came in at a lower-than-expected 0.2% month/month. And not all of this was driven by noise, as the Median and Trimmed CPI series also declined in May from 0.3% month/month for both in the preceding month to 0.2% and 0.1% respectively. However, both underlying CPI inflation series maintained a notable overshoot relative to the Fed's 2% inflation target over a six-month period (chart above).
Although different, trimmed CPI and PCE indices exhibit notable co-movements, especially expressed in target deviations, as can be seen in the chart above. These enable statistical nowcasts of Median and Trimmed Mean PCE inflation, which are published later this month, and these suggest a continuation of underlying PCE inflation around 2.8% versus the Fed's 2% target (gray and purple diamonds in the chart above).
Are Real Rates Restrictive Enough?
To gauge how restrictive the Fed’s interest rate policy is I published back in August 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 1.39% at this point in June, 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 April and May relative to Q1, the expected restrictiveness of the Fed’s policy stance edged up since Q1 as more rate cuts were priced out of the market rates.
The Fed’s Own View
FOMC members updated their forecasts for inflation, growth the unemployment rate and the Fed funds rate at this meeting. The inflation outlook was modified relative to March, especially for 2024 where 2024 Q4/Q4 core PCE inflation projection was upgraded to 2.8% from 2.6% previously. Beyond 2024 the Q4/Q4 core PCE inflation projections also moved up for 2025 from 2.2% to 2.3%. The SEP projections for growth and unemployment remained essentially unchanged relative to the March SEP.
The median Fed funds projection for 2024 in this updated SEP dropped from three rate cuts towards one. More strikingly, the number of FOMC members that penciled in at most one rate cut for 2024 went up from 4 in the March SEP to 11 in today’s SEP update. Instead, FOMC members pushed more rate easing into next year, as the number of cuts for 2025 increased by about one to a total of 100bps worth of cuts.
The Fed’s quarterly Summary of Economic Projections (SEP) provides a clue about the range of views within the FOMC on R*, using the central tendency for the longer run Fed funds rate and PCE inflation, respectively. The chart above suggests that compared to March the distribution of FOMC members’ own assessment of the neutral real rate skewed up further, enough to shift up the median R* estimate from 0.6% to 0.8%. The Fed’s R* guesses are slowly converging towards estimates from models and market data.
The chart above contrasts my surveys-based one-year real rate relative to the average of model- and market-implied R* estimates with a proxy of the Fed’s view on this real rate gap using information from its own Summary of Economic Projections (SEP). This chart suggests that since the March FOMC policy stance expectations from “Main Street” and markets have been in line with the Fed’s own assessment of the restrictiveness of its stance over the year. This partly reflects, however, more disagreement amongst FOMC members since March with regards to the degree of restrictiveness of their policy stance (given the widening of the red dots in June compared to March in the above chart).
Looking Beyond Today
Recent data have been encouraging for the Fed in terms of a possible pickup in disinflation going forward, including monthly spot inflation data gaining back some disinflation momentum in April and May. However, the underlying inflation data suggests we need to see at least three consecutive months of weak inflation data readings before such a disinflationary trend indeed has become more apparent.
Between today and the September meeting we will get three reports for both the CPI and PCE price indices. Combined with a solid but no longer hot labor market it does makes sense for the Fed to keep the Fed funds rate on hold to allow it to gain more confidence from the incoming data to whether the economy indeed is back on track towards a trend inflation rate around 2%.
Today’s CPI inflation data as well as recent readings on household income growth and spending solidify the September FOMC meeting as the likely starting point of a rate easing cycle aimed at bringing the policy rate gradually back towards neutral. Any lack of progress in the forthcoming data releases over the summer, however, will push out rate cuts. And in that particular case it likely will mean no rate cuts at all this year given the FOMC’s own uncertainty about how restrictive its policy stance really is at the moment.