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Economic Monitor – Weekly Commentary
by Eugenio Alemán

One way we could explain the latest FOMC decision: Rise over run

June 14, 2024

What do we mean by ‘rise over run?’ For those of you that are math geeks, you will get it fast enough. However, for those of you who are not math geeks, ‘rise over run’ is the formula for the slope of a line. What does this have to do with the latest Federal Reserve (Fed) decision, you may ask? Please be patient as we try to explain what we mean.

Here goes. By mid-year last year, Fed officials were calling for a terminal federal funds rate for this tightening cycle of about 5.75% for the upper band of the federal funds rate, with a median of 5.6%. However, over the course of the second half of 2023, and as inflation was slowing down further, the Fed started to lower its view on the terminal rate and settled on a terminal rate of 5.25% to 5.50%, which is the rate we have today.

This federal funds rate is the ‘rise’, that is, the height that determines one of the components of the slope of a line. On the other hand, the ‘run’ is, in this case, the duration or for how long the rate is going to remain at this level in order to achieve the Fed’s target of 2% for the PCE price index.

At some point last year, Fed officials thought that 5.50% (the ‘rise’) for the federal funds rate was going to be enough to bring down inflation to the 2% target rate over the long term and thus were expecting the ‘run’ to remain relatively short so they could lower rates three or more times this year. However, the very small increase in inflation during Q1 seems to have made them much more risk-averse and we are now expecting the ‘run’ to be much longer than before, with only one expected cut during this year compared to at least three earlier this year.

Of course, Fed officials could have chosen to increase the federal funds rate and keep the three cuts they expected to make during this year, but instead they decided to extend the run for a longer period of time, or what everybody is calling ‘higher for longer’.

We think the biggest risk with this decision is that the longer the Fed stays at the current nominal federal funds rate in an environment in which economic news is so fluid, with many indicators pointing to further weakness and inflation continuing to trend down, the more strains this is going to put on the economy as the real federal funds rate continues to increase. Reducing the rate cuts from three to one implies tightening monetary policy compared to expectations back in March of this year. That is, even though the Fed did not increase the ‘rise,’ the extension of the ‘run’ will mean tighter monetary policy compared to the previous expectations.

We understand that fiscal policy remains extremely expansive, and the Fed may be afraid that this fiscal expansion could keep inflation higher than what had been expected. However, everything we are watching is pointing to further weakness in economic activity, which continues to be supportive of the disinflationary process.

Furthermore, as the Fed Chairman indicated during the press conference after the FOMC meeting, some economists have challenged the strength in nonfarm payrolls due to underlying issues with the model the BLS uses to forecast business births and deaths. Thus, if the labor market is weaker than what the nonfarm payroll number is showing, we believe it would have been safe to keep the two to three rate cuts the Fed had projected earlier this year.

Monetary policy is very tight today and will get even tighter in the coming months. This is very clear when looking at bank lending in the graph below. Recall that what is important is inflation- adjusted, or real, lending, not nominal lending. Even credit card lending, which was growing too fast, is coming down to earth. So as a monetary economist would say, there is no breathing room for inflation to come back and justify such risk aversion from policymakers. That is, a delta of 20 basis points (bps) in expected inflation for this year does not justify a 50 bps in reduced rate cuts. Furthermore, the current soft landing of the U.S. economy is at risk.

The year is still young and if Fed officials changed their views on the terminal rate relatively quickly last year, they could do the same thing once they see inflation continuing to trend down during the second half of the year.

Federal funds rate math after the June FOMC decision

Given the June Summary of Economic Projections (SEP) and dot plot we need to adjust our federal funds rate call. We still think there is a relatively clear path to two rate cuts this year but considering that the new dot plot only has one cut we need to take this new dot plot into consideration.

If by September of this year, which is when the new SEP and dot plot are going to be released, GDP growth and inflation has remained in line with Fed official’s forecast, then we estimate that the Fed will not lower interest rates in September because it risks being accused of favoring one political side ahead of the presidential elections. Thus, if there is only one rate cut this year, we estimate that the Fed will move in November, as it meets just after the presidential election.

However, if economic growth and inflation go according to our weaker economic forecast and stronger disinflationary environment, then a September rate cut opens up again while a second rate cut could occur either in November or December.

Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those Raymond James and are subject to change without notice the information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the U.S. Bureau of Labor Studies. Currencies investing are generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

The National Federation of Independent Business (NFIB) Small Business Optimism Index is a composite of ten seasonally adjusted components. It provides a indication of the health of small businesses in the U.S., which account of roughly 50% of the nation's private workforce.

The producer price index is a price index that measures the average changes in prices received by domestic producers for their output. Its importance is being undermined by the steady decline in manufactured goods as a share of spending.

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