Will FED cut rates despite neutral inflation?

>> Will the FED soon follow other central banks in rate cuts?

Some argue that a rate cut is needed, others believe that the Fed is more likely to signal at this meeting that rates will likely be cut at the September 18^th get together.

The argument for action now is not just based on some good inflation prints recently but also the belief that the labour market might not just be rebalancing back to where it was before the inflation surge and Covid, but is showing signs of overcorrecting; a trend that puts the full-employment component of the Fed’s dual mandate in doubt.

For instance, there’s been a focus on the so-called Sahm rule that states a recession is likely if the average rise in the unemployment rate over a three-month period is 0.5% points or more above the low seen over the previous year. Right now, the US is very close to this point. Various other statistics are used to suggest that the labour market is not as robust as headline data, like payrolls might suggest. For instance, the household measure of employment, which is used to calculate the unemployment rate has shown virtually no increase over the past year.

The problem, it would seem, for the Fed is that even if it is accepted that the full-employment side of the dual mandate is in jeopardy, inflation is still above target with PCE prices running at 2.6% at the moment. The Fed could keep the emphasis on achieving the target and persist with very restrictive policy in order to squeeze the last vestiges of inflation out of the economy, but would this be the right thing to do?

Steve Barrow, Head of Standard Bank G10 Strategy does not think it is the right thing to do and do not believe it is the approach the Fed will take. One reason for this is that we sense that the ‘equilibrium’ or ‘neutral’ inflation rate has likely risen and probably sits above 2%. Indeed, he thinks this may be the case for many countries. The reasons for this reflect issues discussed before such as deglobalisation and demographics. The former speaks to the unwinding of the positive global supply shock that came primarily from China’s increased integration into the global economy, particularly after its accession to the WTO in 2001. This has now stalled, if not reversed.

Demographics relates largely to the rise in the so-called dependency ratio, which is the ratio of retirees to those in the working population. Working people contribute to both the demand and supply of goods and services, retirees only to demand. Hence, as this ratio rises, demand increases relative to supply, and that can lift what we might call the ‘neutral’ inflation rate.

>> Will the FED cut rates in September?

Steve Barrow thinks there are other hints that a 2% inflation target might be too low. One is that if we look at market expectations for inflation, like 5-year-5-year inflation swaps, we very rarely see these at, or below, the 2% level. And then there’s the Fed itself which, in switching to an average inflation target back in 2020 surreptitiously accepted that it might be better to aim for faster price growth than previously. This might have primarily reflected the problem the Fed had with undershooting inflation in the pre-pandemic period, but we also believe that there’s a tacit acceptance here that straining to get to 2%, or lower, is just too much.

Of course, the Fed will never accept that it has gone soft on inflation and it will likely never lift its inflation target, which might be thought of as the ‘neutral’ inflation rate. Nonetheless, it is what the Fed does that is of importance, not what it might say and, right now, many analysts suspect that it will ‘say’ at its July 31^st meeting that, barring unforeseen events, rates will be cut in September.

“We dare say that many will argue that the Fed is falling behind the curve again in doing this, just as it did when it started the rate hike cycle in March 2022. But at least if it signals an easing cycle from September it will encourage the easing of financial conditions that should set in train policy accommodation even before the first cut”, said Steve Barrow.