Don't Sleep on a September Rate Hike
Updated: Aug 3
Markets aren't pricing in another 25bps hike in September, but they should be.
3 THINGS YOU NEED TO KNOW
Inflation headlines will be less optimistic for July data. Core PCE inflation – the Fed’s preferred measure – will rebound when we get the data for July later this month. That’s going to make some headlines. Don’t get tied in knots, inflation is still cooling. The increase will be driven by technical factors that have to do with the reference point from 12 months ago. These “base effects” are discussed in more detail below. Figure 1 illustrates how these statistical mechanics can change a forecast. If you plug in the relatively slow monthly change for June to estimate July, the yearly change in inflation rises. If there’s no change in monthly price pressures, we’d get the same yearly rate we saw in June.
Financial markets have the wrong rate forecast. Earlier in the cycle, the Fed wanted to telegraph future rate moves. Economists call this type of communication forward guidance, and it’s a crucial factor in allowing markets and businesses to avoid surprises and adjust to changes in financial conditions. That time is over. We’re near the peak of the rate cycle and policymakers will increasingly value optionality over clarity as they fine tune their forecasts and decisions. That was on full display at the post-meeting presser when Powell answered questions as only economists can: on one hand, and then on the other. Markets expect a pause at the September meeting with the futures market placing a greater than 80% chance that the Fed stands pat. A/M disagrees and expects another 25bps hike in September as solid labor market data puts pressure on policymakers to do just a little more to make sure wage inflation doesn’t become entrenched.
Equity markets won’t be as rosy in the second half. There have been a lot of surprises in 2023, but one of the biggest has been the strength of equity markets. A rebound in tech stocks, cost-conscious business plans, and a recession that has yet to materialize were big boosts. But time catches up to us all. Economic activity in the second half of the year is likely to at least slow. And A/M doesn’t expect the Fed to start easing until the first quarter of next year. Elevated rates and slower, or contracting, economic growth will translate into a weaker second half for equities.
The June inflation deceleration wasn’t all that it seemed. The core PCE price index grew slowly from May to June (0.165%), the slowest monthly pace since July 2022. The yearly change in core PCE inflation dropped from 4.6% to 4.1%, a decline of 0.5 percentage points. Sadly, the cooling was overstated. Only about 0.2 percentage points of the drop was due to a deceleration in price growth (endnote a). The remaining 0.3ppt can be attributed to a technical phenomenon known as “base effects”. Think of it like this: the 12-month change in measures inflation against what was going on a year ago. As new data comes out, that reference point moves forward in time. For instance, last month we got data for May, which means May 2022 was the reference point. When the June data arrived, that reference point moved forward to June 2022. There was an inflationary surge at the start of last summer which rolled out of the 12-month change once May 2022 was dropped. That echoed through to today’s data and mechanically slowed that June 2023 yearly change. History tells us that the monthly speed of inflation is unlikely to remain as sluggish as it was in June without the economy entering a recession.
It’s still going to take a while for inflation to hit 2%. That slow monthly inflationary rate for June was still above the average experienced from 2015-2019. And a few components tied to the health of the economy, like recreational services, showed continued strength. Those are two good reasons not to get overly excited about the June inflation release. Last month A/M laid out why inflation is likely to ease gradually. Those reasons didn’t change with the latest data. Our forecast has core PCE inflation reaching 2% in April of 2024.
The decline in vehicle prices will be uneven and slower than many expect. A drop in used car prices accounted for a decent amount of disinflationary pressure in June. It was the first drop in three months, and more are on the horizon. Demand and supply are still coming into post-pandemic alignment as higher borrowing costs and tighter lending standards depress demand, and healing supply lines will boost production. Those factors strongly suggest that prices will decline further and that the inventory-to-sales ratio will continue to slowly rebound from historic lows. However, business models have changed, and dealers are reported to be focused on keeping lower inventory levels going forward. That will likely take some of the speed off price declines as demand is expected to cool, but not fall off a cliff.
The Fed will lower rates before inflation reaches 2%. We’ve known it for some time, but Chair Powell confirmed it at the July press conference that followed the FOMC meeting: even without a recession, officials expect to lower rates before inflation hits 2%. Here’s why:
Real borrowing costs will climb further. The real cost of borrowing is measured by the inflation-adjusted interest rate. As real rates rise, the cost of deploying money as opposed to keeping it in a bank account goes up, making some projects undesirable. That weighs on economy-wide investment and GDP. The real rate of interest is estimated by taking the nominal rate and subtracting out short-run inflation expectations. Right now, that rate is roughly 1.75%, depending on which interest rate and measure of inflation expectations is used (endnote b). Models estimate that the real rate of interest (r*) when the economy is humming along at its sweet spot is around 1.1% (reference 1). If you just look at the pace of inflation over the last couple of months, it’s right around an annualized rate of 2%, which means the real rate of interest that consumers and businesses are actually experiencing is likely higher than what is being reported. Adding to the pressure, easing inflation will automatically raise the real rate of interest even if the Fed is done tightening.
A soft-landing needs lower borrowing costs. Policymakers still believe they can land the plane on the runway without setting it on fire. Whether that is possible or not will depend in big part on what happens to economy-wide investment over the next nine months. Inflation-adjusted investment rebounded in the second quarter, despite elevated financing costs, giving some hope that policymakers are on track to deliver. However, the gains were largely concentrated in sectors that were slammed over the last six months, like transportation, or those that got a boost from government legislation, like manufacturing (reference 2). A/M expects those boosts to fade and still places the probability of a recession at 50% in the next three quarters. The Fed will need to lower borrowing costs before inflation hits target if there’s any chance to avoid a downturn.
(a) To calculate the amount attributable to base effects, A/M used the average monthly rate of changes in the previous three months to estimate a counterfactual June 2023 index value.
(b) For simplicity, the real rate was calculated using the midpoint of the current federal funds rate range of 5.13% minus the July 2023 one-year ahead inflation expectations from the University of Michigan Survey of Consumers.
1. Laubach, Thomas, and John Williams. “Measuring the Natural Rate of Interest.” Federal Reserve Bank of New York. Accessed July 31, 2023. https://www.newyorkfed.org/research/policy/rstar.
Tim Mahedy is the Founder and Chief Economist of Access/Macro – a consultancy focused on uncomplicating the economy so that your business can make better decisions.
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