Tiptoeing Close to the Edge

The US Federal Reserve will conclude its fifth Federal Open Market Committee (FOMC) meeting of the year on July 31. Although the market isn’t expecting a change in policy at this meeting, the Fed’s communications should set the stage for a September rate cut.

For the Federal Reserve to begin cutting rates, it is crucial that inflation, as measured by the Personal Consumption Expenditures (PCE) deflator, moves closer to the Fed’s 2% target. Data released last week show that PCE inflation fell to 2.5% year-over-year in June, down from 2.6% in May and significantly lower than its peak of 7.1% in June 2022. On a three-month annualized basis, core inflation is running at just 2.3% – barely above the Fed’s long-run target. 

Speaking at The Economic Club of Washington, D.C., just two weeks ago, Fed Chair Powell highlighted why the Fed would not and should not wait for inflation to hit 2% before deciding to cut interest rates. Higher-frequency data suggest that, after staying at 2.5% year-over-year in July, inflation could resume its decline over the rest of the summer, potentially touching the Fed’s 2% year-over-year target as early as September.

Last week’s initial estimate of second quarter U.S. GDP growth jumped well above consensus expectations to a 2.8% annualized rate, up from a soft 1.4% in the first quarter. If the first-quarter real GDP reading of 1.4% understated economic momentum due to a sharp reduction in inventory growth, the second-quarter number suffered from the opposite challenge: an acceleration in inventory accumulation. A clearer picture emerges from the path of real final sales, which excludes inventories: real growth was 3.5% for the year ending in the fourth quarter, but it slowed to 1.8% annualized in the first quarter of 2024 and 2.0% in the second quarter.

A sturdy second quarter and first half GDP growth performance does little to change the view for the US economy. Financial markets and most economists still anticipate that the Federal Reserve will cut the federal funds rate by 25 basis points following the September 17-18 FOMC meeting. There is ongoing debate over whether restrictive monetary policy operates with a “long and variable” lag, potentially necessitating further rate cuts later this year to prevent a recession in late 2024 or 2025. The market, however, anticipates more rate cuts within the year. According to the Atlanta Fed’s Market Probability Tracker, the expected three-month Fed Funds rate by year-end is 3.57% (with a range of 2.67% to 4.47%).

Source: Federal Reserve Bank of Atlanta