The Bottom Line:
- Inflation is coming down, with core PCE closing in on 2.5%, ahead of the Fed’s projections
- Signs of slower job growth, rising unemployment rate, and potential for rate cuts by the Fed
- Bifurcations in economic data, such as goods vs. services and discretionary vs. non-discretionary inflation
- Challenges for the Fed in using monetary policy to target specific sectors of the economy
- Expectations for the Fed to focus on overall inflation trends and labor market slowdown for policy decisions
Inflation Trends: Core PCE Nearing Fed’s Target
Inflation Easing but Remains Uneven
Inflation has been coming down, and despite the sentiment that it’s not declining quickly enough or may never reach the Fed’s 2% target, core PCE is actually getting close to where the Fed wants to see it. The Fed’s projections indicate they expected core PCE to be around 2.5% by the end of this year, which is six months ahead of their earlier projections. This is good news on the inflation front, and if the trend continues, it sets up the potential for some rate cuts by the Fed.
Fed Watching Key Economic Indicators
In addition to inflation, the Fed is closely monitoring employment data. There are signs of slower job growth, fewer job openings, and most importantly for the Fed, the unemployment rate is starting to rise. It’s already up to 4% from a low of 3.5% last July. The last piece of the puzzle for the Fed would be a slowdown in wage growth, which is currently running at about 4% year-over-year. If productivity continues to be strong, a 3% wage growth rate would not be out of the question for keeping demand-side inflation in check.
Rate Cuts on the Horizon?
Overall, assuming the key economic indicators continue to move in the right direction, we’re looking for two rate cuts from the Fed, potentially starting in September and then again in December. However, it’s important to note that monetary policy is a blunt tool and cannot precisely target specific segments of the economy. The Fed may have to make a decision on whether to focus on the overall numbers or parse out the wants-versus-needs components of inflation more carefully. Ultimately, if inflation continues to trend lower and there is a slowdown in the economy, particularly in the labor market, the Fed may not wait for every component to reach the 2% target before taking action.
Shifting Labor Market Dynamics: Slower Job Growth and Potential Rate Cuts
Inflation Easing but Remains Uneven
Inflation has been coming down, and despite the sentiment that it’s not declining quickly enough or may never reach the Fed’s 2% target, core PCE is actually getting close to where the Fed wants to see it. The Fed’s projections indicate they expected core PCE to be around 2.5% by the end of this year, which is six months ahead of their earlier projections. This is good news on the inflation front, and if the trend continues, it sets up the potential for some rate cuts by the Fed.
Fed Watching Key Economic Indicators
In addition to inflation, the Fed is closely monitoring employment data. There are signs of slower job growth, fewer job openings, and most importantly for the Fed, the unemployment rate is starting to rise. It’s already up to 4% from a low of 3.5% last July. The last piece of the puzzle for the Fed would be a slowdown in wage growth, which is currently running at about 4% year-over-year. If productivity continues to be strong, a 3% wage growth rate would not be out of the question for keeping demand-side inflation in check.
Potential Rate Cuts on the Horizon
Overall, assuming the key economic indicators continue to move in the right direction, we’re looking for two rate cuts from the Fed, potentially starting in September and then again in December. However, it’s important to note that monetary policy is a blunt tool and cannot precisely target specific segments of the economy. The Fed may have to make a decision on whether to focus on the overall numbers or parse out the wants-versus-needs components of inflation more carefully. Ultimately, if inflation continues to trend lower and there is a slowdown in the economy, particularly in the labor market, the Fed may not wait for every component to reach the 2% target before taking action.
Economic Bifurcations: Goods vs. Services and Discretionary vs. Non-Discretionary Inflation
Goods vs. Services Inflation Dynamics
The pandemic has led to a notable bifurcation between goods and services inflation. Initially, the stimulus-fueled growth and inflation surge was concentrated in the goods sector. However, this has since rolled over, with some breakdowns even showing deflation in consumer-oriented products. On the other hand, the services side has seen offsetting strength, which has helped support the labor market given the larger employment share of the services sector. By nature, services inflation tends to be stickier, which has prevented inflation from falling to the Fed’s target as quickly as desired.
Discretionary vs. Non-Discretionary Inflation
Another interesting bifurcation within the inflation data is the divergence between discretionary and non-discretionary components. The non-discretionary, or “needs,” components of the Consumer Price Index (CPI), such as healthcare and insurance costs, are still running at about a 6% inflation pace. In contrast, the discretionary, or “wants,” components are hovering around the zero line and could potentially dip into deflation territory. This poses a challenge for the Fed, as their primary tool of interest rate policy can substantially affect the demand side of the economy, but may have limited impact on the sticky non-discretionary components of inflation.
Challenges in Targeting Specific Inflation Components
Monetary policy is often described as a blunt tool, as it affects the entire economy simultaneously and cannot precisely target specific segments. While some areas, such as housing, are more interest-rate sensitive, the Fed may struggle to surgically strike inflation in certain sectors. The Fed faces a decision on whether to focus on overall inflation numbers or carefully parse out the wants-versus-needs components. Ideally, they would like to see all components converge near the 2% target, but this may prove challenging to achieve through monetary policy alone. Factors such as healthcare and insurance costs are influenced by global trends, legislation, and other complex dynamics that are difficult for the Fed to directly address.
Monetary Policy Limitations in Targeting Specific Economic Sectors
Limitations of Interest Rate Policy
Monetary policy, primarily implemented through interest rate adjustments, is often referred to as a blunt tool. While it can effectively influence the overall economy, it lacks the precision to target specific sectors or components of inflation. The Fed’s interest rate decisions can have a substantial impact on the demand side of the economy, but their ability to address sticky non-discretionary inflation components, such as healthcare and insurance costs, is limited.
Balancing Inflation Targets and Economic Stability
The Fed faces a challenging decision in determining whether to focus on overall inflation numbers or to carefully parse out the wants-versus-needs components. Ideally, the central bank would like to see all inflation components converge near the 2% target. However, achieving this through monetary policy alone may prove difficult, as some sectors are influenced by complex global trends and legislation that are beyond the Fed’s direct control. Waiting for every component to align with the target could potentially lead to an overly restrictive policy stance, risking economic stability.
Navigating the Path Forward
As the Fed navigates the current economic landscape, it will likely monitor the overall trend in inflation rather than waiting for perfect alignment across all components. If inflation continues to trend lower and there are clear signs of a slowdown in the economy, particularly in the labor market, the Fed may opt to take action, such as implementing rate cuts, even if some sticky components remain above the 2% target. Striking the right balance between managing inflation and supporting economic growth will require careful consideration of the limitations of monetary policy tools and the unique dynamics at play in different sectors of the economy.
Fed’s Focus on Overall Inflation and Labor Market Slowdown for Policy Decisions
Fed Focusing on Overall Inflation Trends
The Federal Reserve is closely monitoring the overall trend in inflation, with core PCE approaching the central bank’s 2% target. Despite concerns that inflation may not decline quickly enough or reach the desired level, recent data suggests that core PCE could be around 2.5% by the end of the year, six months ahead of the Fed’s earlier projections. This positive development in the inflation outlook raises the possibility of rate cuts, should the trend continue.
Labor Market Slowdown as a Key Indicator
In addition to inflation, the Fed is paying close attention to the labor market, which is showing signs of a slowdown. Slower job growth, fewer job openings, and a rise in the unemployment rate from 3.5% last July to 4% currently are all important factors in the Fed’s decision-making process. A deceleration in wage growth, currently at 4% year-over-year, would be the final piece of the puzzle. If productivity remains strong, a 3% wage growth rate could be sufficient to keep demand-side inflation in check.
Potential Rate Cuts on the Horizon
If key economic indicators continue to move in the right direction, the Fed may implement two rate cuts, potentially starting in September and followed by another in December. However, it is crucial to recognize that monetary policy is a blunt tool, and the Fed may need to decide whether to focus on overall numbers or carefully parse out the wants-versus-needs components of inflation. While the ideal scenario would be for all components to converge near the 2% target, the Fed may not wait for perfect alignment before taking action, especially if there is a clear slowdown in the economy and the labor market.
