Key Points:
- A week’s worth of inflation data shows significant easing of price pressures since the 2021-22 surge.
- Federal Reserve officials head into their two-day policy meeting closer to their low inflation target, but the extent of interest rate cuts is still unclear.
- “The federal funds rate has been over 5%, has been there for over a year to fight inflation. That fight is won. They need to start getting out of the way,” economist Claudia Sahm said.
As the Federal Reserve prepares for its two-day policy meeting, it is entering with clear evidence that inflation is slowing, but how much they will reduce interest rates is still up for debate.
Over the past week, inflation data indicated that price pressures have eased significantly from their peak in 2021-22. One indicator showed 12-month consumer inflation at its lowest since February 2021, while wholesale prices suggest that pipeline price increases are under control.
These positive signs have paved the way for a potential interest rate cut at the Federal Open Market Committee meeting, which will conclude on Wednesday with a decision on rates and an updated forecast for the future.
“We got two more months of good inflation data” since the last Fed meeting, said Claudia Sahm, chief economist for New Century Advisors, in a CNBC interview. “That’s what the Fed asked for.”
However, the question now is how aggressively the Fed should cut rates. Financial markets, which often predict the central bank’s direction, shifted focus over the week. Initially, traders were expecting a quarter-point rate cut, but by Friday, they were split between a 25 basis point or 50 basis point reduction, according to the CME Group’s FedWatch tool.
Sahm advocates for a larger move. She argued, “The inflation data on its own would have gotten us 25 next week, as it should, and will get us a whole string of cuts after that. The federal funds rate has been over 5%, has been there for over a year to fight inflation. That fight is won. They need to start getting out of the way.”
She suggests the Fed should kick things off with a 50 basis-point cut to stabilize the labor market, which has shown signs of weakening. “The labor market [since] last July has gotten weaker,” Sahm added. “So there’s an aspect of just recalibrating. We got some more information. [Fed officials] need to kind of clean it up, do a 50 basis point cut and then be ready to do more.”
Confidence in Inflation Control
While the battle to bring inflation back down to 2% isn’t completely over, recent reports suggest it’s headed in the right direction.
The consumer price index (CPI) rose just 0.2% in August, bringing the annual inflation rate to 2.5%. Excluding food and energy, core inflation remained at 3.2%, still above the Fed’s target.
Much of the core inflation’s strength has come from high shelter costs, influenced by the Bureau of Labor Statistics’ measure known as “owners’ equivalent rent,” which rose 5.4% over the past year and accounts for about 27% of the CPI.
Despite lingering inflation pressures, consumer surveys reflect growing confidence that inflation is easing. A University of Michigan survey in September showed respondents expecting inflation to be at 2.7% over the next 12 months, the lowest since December 2020.
Taking the various dynamics into account, Fed Chair Jerome Powell said in late August that his “confidence has grown” that inflation is trending back toward 2%.
However, employment remains a concern. Powell remarked in the same speech at the Fed’s annual retreat in Jackson Hole, Wyoming, that the Fed does “not seek or welcome further cooling in labor market conditions.”
With the Fed balancing its dual mandate of price stability and full employment, the focus may be shifting toward protecting the job market.
“If Powell wants to deliver on his, ‘we want no further weakening, no further cooling,’ they are going to have to, like, really move here, because that cooling trend is well established,” Sahm said. “Until it is interrupted, we are going to continue to see payrolls drift down and [the] unemployment rate drift up.”
The Case for a Smaller Rate Cut
Despite the push for a larger cut, there is still support for a quarter-point reduction. This would allow the Fed to make further progress on inflation while keeping a close eye on the broader economy and labor market.
“That’s really the key that they need to kind of hone in on, which is that they are normalizing policy and not trying to provide accommodation for an economy that is really in trouble,” said Tom Simons, U.S. economist at Jefferies. “I think they’ve done a very good job of expressing that point of view so far.”
Even with a smaller quarter-point cut, the Fed would retain flexibility to make further moves as needed. Market expectations currently predict a 1.25 percentage point rate reduction by the end of 2024, reflecting a sense of urgency to bring borrowing costs down from the current 5.25% to 5.50% range, the highest in over two decades.
“The whole reason why they’ve been so cautious about cutting is because they’re concerned that inflation is going to come back,” Simons explained. “Now, they have more confidence based on data that suggested [inflation] isn’t coming back right now. But they do need to be very careful to monitor potentially changing dynamics.”
