Inflation Spikes In June, Complicating The Fed’s July Decision
Inflation is up. The June Consumer Price Index (CPI) showed core inflation rising 2.1% year-on-year in June. That’s slightly above the Federal Reserve’s (Fed’s) 2% target and unemployment is also in a good place today. So why is the Fed looking to cut rates? As a sanity check, the last time we had unemployment around 4% and inflation at 2% was late 1999 and then the Fed funds target rate was at 5%. More than double current levels. Furthermore, the Fed was actually hiking rates then, not cutting them. Of course, we are in a different in environment now in many ways, but the comparison still has meaning.
Yet a cut at the end of this month is seen as virtually certain based on interest rate futures. In fact, the debate has shifted from not whether a cut is coming, but whether it will be 0.25% or 0.50% cut for some market participants. Yet, most still see a single cut as most likely. So what’s going on? Rates seem low today and yet they are going lower. There are several things that complicate the Fed’s position despite the rosy state of unemployment and robust inflation.
A Storm On The Horizon?
The Fed is looking ahead beyond today’s data. It is worried about the global economy. The yield curve is inverted. That’s typically a bad sign for markets and the economy. Inverted yield curves have historically predicted recessions. The one way the Fed can control that is by cutting rates. Inversion is when short rates are above longer term ones. The Fed can potentially manage that by cutting short rates to below long term ones. Of course, the Fed is far more interested in managing the economy than managing the esoteric aspects of yield curve, but it is a consideration. Especially when some argue that the mechanics of yield curve inversion removes the incentive to lend for the longer term, which may itself prompt recession.
Furthermore, manufacturing is softening. In addition, the U.S. is among the stronger international economies, and global growth is a concern. These are all things for the Fed to worry about. Indeed, as Powell himself said, “It appears that uncertainties around trade tensions and concerns about the strength of the global economy continue to weigh on the US economic outlook.”
Political Influence And The 2022 Decision
President Trump has been pushing for lower rates over the past 12 months. The Fed Chair, Jerome Powell came out and said that he wouldn’t leave if Trump tried to fire him in his recent testimony. Nonetheless, the fact that he was asked the question and the that Trump has asserted he has the right to fire Powell, even though many disagree with that view, may be weighing on Powell. Trump’s increasing ire with his Fed chair and the Fed’s move to withdraw from hikes to a potential rate cut have followed a similar timeline. This despite the Fed’s independence on paper.
It’s likely true Trump can’t fire Powell now. Powell knows that. It’s important to note though that he can certainly chose not to reappoint him in 2022, should Trump serve a second term. Powell may well worry about that. As a result, Powell may legitimately not be concerned in the short-term, but there are potential long-term implications from Trump’s lack of enthusiasm in his Fed chair. The obvious example here is Trump’s decision not to reappoint Yellen, apparently for much lesser disagreements.
With his public statements, Powell, and the other Fed decision makers, may now be locked on a rate cut in a few weeks, without dramatic change in the data, which seems unlikely. The Fed carefully manages its public statements, which are a large part of its economic influence. It has carefully spent the best part of a year moving from a position of hiking rates, to one of broad neutrality , to the current situation where the balance of risks seem to be to the downside and a cut seems probable.
In fact, it is potentially the very prospect of a rate cut that may have supported markets in recent months. Therefore, the Fed’s decision process becomes yet more complex. Even though they haven’t cut rates yet, that assumption is baked into markets. Almost as if the move as already happened. The Fed changing their mind would likely be a painful move for both stocks and bonds. Just as the Fed looks ahead in its setting policy, so do the markets in weighing future Fed actions.
So the data is rosy today, but many factors weigh on the Fed’s decision processes. It’s unlikely favorable inflation and unemployment data will avert a hike later this month. The bigger question is whether we’re looking at an insurance cut or the start of an easing cycle. That will be data dependent.