Inflation and Rates - What’s Next?

Answer:  It’s a bit of an understatement to say that the Fed is in a state of flux. Let’s take a minute to discuss the relationship between interest rates and the labor market. Interest rates were at historic lows during the Covid pandemic when cash was infused into the economy. Interest rates are the cost of money. During the shutdowns, money flowed and was inexpensive. As we came out of the pandemic, the economy picked up steam and inflation (too few goods being chased by too many dollars) began to take off. The Fed increased interest rates (the cost of money) to slow inflation and cool down the “too hot” economy. So here we are today with the Fed not quite ready to lower interest rates.

While jobs remain in the steady to strong category, the Fed is biding their time for higher rates to do the job while remembering that monetary policy has a lag factor to impact the economy. The economy continues to grow, although at a slower rate while we wait. There are events The Fed has no control over, such as geopolitical risks that impact commodity prices and supply chains. The big question is, are Fed officials willing to start lowering interest rates potentially increasing the money supply and be comfortable with the path for inflation? 

When and if the Fed lowers rates, they have other tools in the toolbox to temper expansionary impact on the economy and keep monetary growth contained. The best known of these is paying interest on bank reserves. We must remain cautious while gauging US economic conditions as it is obviously clear that post-pandemic metrics have made some of our “tried and true” indicators such as inflation and employment numbers less reliable. 

The purpose of the Fed  as the Central Bank of the United States is to pursue full employment and stable prices while influencing monetary conditions to do so. The desirable inflation rate target historically is 2% with maximum employment which depends on business conditions, demographics, labor markets and regulations with a target unemployment rate between 3-4 percent. Those current numbers are 3.2 % and 3.8% respectively.

The Federal Open Market Committee (FOMC) believes that an inflation rate of 2% provides price stability and maximum employment. The theory is that this sort of environment allows consumers to make prudent decisions when taking on debt, saving, and investing. The Fed is an independent entity ultimately accountable to the public and Congress. The Fed Funds rate established by the FOMC is the rate that banks charge each other for short-term loans. The Fed has no specific role in setting prime rate but certainly influences rate levels. At the time this is being written, the Fed Funds Target rate is 5.25% - 5.50%. (See chart) 

To achieve the Fed inflation target rate of 2% we need to see monthly average rates of Personal Consumption Expenditures (PCE) index between 0.15% – 0.17% % (2% divided by 12 months =  0.1667). The easy part of reducing  inflation was accomplished early on with the incremental change being more challenging for the Fed to achieve a reduction from a 3.2% to 2% inflation rate. 

We don’t know exactly how long, and how tough the path going forward will be. 

Another school of thought by some analysts is that we may need to accept and expect an inflation rate higher than 2% in the future. The interconnectedness of this “cost push” pressure on wages and employment is a delicate relationship to follow closely. Is the Fed willing to adjust the target inflation rate, and what might be the consequences?

We’ve presented more questions than answers today. Here’s an analogy that may help to clarify the concepts. If in a meeting with your boss, you’re provided with a performance target number that will dictate your bonus and raise amount,  you start the year with that target in mind and do everything to achieve the goal, making modifications along the way to hit your numbers. Similarly, if the Fed’s “best” isn’t enough to hit their target, they’ll need to adjust policy to achieve the long-term 2% inflation goal. The Fed patiently estimates they’ll reach the 2% target by 2026. Therefore, the answer to your question about the timing of rate cuts, is “it depends.” Stay focused and plan accordingly.