As we start the second half of the year and as we approach next week’s release of the preliminary report on real GDP for the second quarter of the year we continue to expect second-half economic growth as well as inflation to downshift compared to what we saw during the first half of this year. The ‘long and variable lags’ of monetary policy will continue to put a cap on economic growth as real interest rates, that is nominal interest rates minus inflation, continue to increase and continue to exert downward pressure on economic activity.
Furthermore, this weaker economic growth will continue to help bring inflation down, slowly but surely, to the Federal Reserve’s (Fed’s) target of 2.0% for the Personal Consumption Expenditures (PCE) price index over the long term. That is, paraphrasing the Chairman of the Fed, Jerome Powell, during an interview earlier this week in which he referenced these ‘long and variable lags’ of monetary policy, he argued that “The implication of that (i.e., long and variable lags) is that if you wait until inflation gets all the way down to 2%, you’ve probably waited too long, because the tightening that you’re doing, or the level of tightness that you have, is still having effects which will probably drive inflation below 2%.”
But what he is really saying is what we have been arguing since the Fed changed its mind during the first quarter of the year regarding interest rates, that is, as inflation continues to fall, real interest rates will continue to tighten monetary policy even if the Fed does not do anything. That is, real interest rates will continue to bite and put downward pressure on economic activity.
After expecting three rate cuts during 2024 earlier this year we have settled on at least two cuts before the end of the year, with the first rate cut coming as early as after the September meeting of the Federal Open Market Committee (FOMC), which is scheduled for September 17-18, 2024, with a second one after either the November or the December meeting of the FOMC.
That is, we believe that the ‘search for more confidence’ on the forward path of the disinflationary process by Fed officials is forthcoming and will accelerate with the performance of the economy during the rest of the year. Furthermore, the fact that, as we have argued on several occasions, the disinflationary process has continued unabated even as the US economy has grown at a faster rate than potential output guarantees that as the economy continues to weaken the disinflationary process will strengthen and will give more confidence to Fed officials that it will be okay to start lowering interest rates.
Pay (More) Attention to the CPI During the Second Half of the Year
You have read from us over the last several years that we have always given reduced importance to the Consumer Price Index (CPI) compared to the Personal Consumption Expenditures (PCE) price index. The reasons are varied but the most important ones are that housing, or shelter costs, are overweighted in the CPI versus the PCE price index while the PCE price index is the one used by the Fed for conducting monetary policy.
The differences are the same between the two indices but because shelter cost increases have started to weaken, together with the fact that shelter costs are about 35% of the weight in CPI versus a 13% in the PCE price index, it follows that if shelter costs are accelerating, then the CPI tends to rise faster and higher than the PCE price index. However, since now it seems that shelter costs are decelerating, then there is the potential that year-over- year CPI starts falling at a faster pace than the PCE price index. Since markets and analysts tend to follow the CPI releases rather than the PCE price index releases, it follows that a potential steeper deceleration of the CPI versus the PCE price index during the second half of the year will have the potential to improve market perceptions regarding the disinflationary process going forward, which will further help Fed officials gain more confidence about inflation.
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