Estimates of the level of the US fed funds rate – the Federal Reserve’s main policy rate – in one year had risen from 1% at the beginning of 2022 to a peak of 3.4% in early May, but it has been stable at between 2.8% and 3.4% over the last two months (see Exhibit 1).
This partly reflects communications from Federal Open Market Committee (FOMC) policymakers about the pace at which they intend to raise rates. It also indicates that investors believe an additional 200bp in policy rate increases will sufficiently slow the US economy to move inflation back towards the Fed’s 2% target.
Each of these assumed levels (the fed funds rate, growth and inflation) need to be internally consistent for them to ultimately be realised. We may yet see them challenged by markets.
If one assumes the potential US GDP growth rate is 1.75%, then the economy arguably needs to grow at a slower pace than this for a while for the non-transitory parts of inflation to decline (or equivalently, the unemployment rate, currently at 3.6%, needs to rise to above the non-accelerating inflation rate of unemployment (NAIRU) of around 4% for a time).
Above-potential growth, so above-target inflation?
Currently, however, consensus economic estimates project the economy growing at an above-potential 2.4% annualised rate for the rest of this year and at 1.9% in 2023. One should remember though that these are the median estimates, so by definition half of the estimates foresee slower (and in a few instances, even negative) rates of growth.
The robustness of these growth forecasts will hinge upon how inflation behaves in the months ahead as that will drive market expectations for the level of fed funds.
For inflation, the Fed focuses on the core Personal Consumption Expenditure (PCE) index, currently running at 4.9%. Its medium-term target is 2%. Many of the factors that have driven headline inflation to the current high levels (rising oil and food prices) should ultimately prove transitory, but the core components are less predictable.
One important core component where we do have more visibility is rent and owners’ equivalent rent (OER). These have a combined 18% weight in the PCE index.
What is propping up inflation?
A study by the Dallas Fed has shown that increases in house prices lead increases in rent and OER inflation by somewhat less than two years. Given that house price growth remains strong (see Exhibit 2), this would suggest that at least these components of core PCE may continue to drive sustained above-target inflation in the months ahead.
The bulk of the remaining parts of the index will need to decline more sharply for the overall measure to move towards the Fed’s target.
Any significant deviation from the desired path could lead markets to price in additional rate rises by the Fed. Alternatively, higher inflation may prompt a slowdown in growth by itself as ‘demand destruction’ ensues, although the resulting stagflation is hardly a more attractive prospect.