WASHINGTON, DC – With inflation cooling and unemployment rising in the United States, investors are betting that the Federal Reserve will cut interest rates. At the time of this writing, market prices imply a less than 2% chance that the Fed will not reduce rates at its policy-setting meeting in September, and even indicate a 7% chance that it will lower rates at the next meeting later this month.
The argument for cutting rates is straightforward. As measured by the consumer price index (CPI), the US experienced no inflation in May and deflation in June. At the same time, the unemployment rate has been trending up since last summer. At 4.1%, it is 70 basis points above its post-pandemic low.
When the unemployment rate goes up a little, it goes up a lot, which is why many believe that the Fed should declare victory in its battle with inflation and begin its cutting cycle. But this view, while reasonable, is mistaken, because it misreads the outlook for inflation and the labor market. The Fed should not cut rates in September, and certainly not this month.
The Fed targets the price index on personal consumption expenditures (PCE), not the CPI. Like CPI inflation, core PCE inflation decelerated in May (June data are not yet available). But using this measure, monthly prices likely grew by around 0.2% in June. According to my calculations, if that pace continues, underlying inflation will be stuck between 2.6% and 3% for the remainder of 2024 – well above the Fed’s 2% target.
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