Under promise, over deliver

Bottom Line

Despite relatively benign May readings on wholesale and retail inflation this week, the Federal Reserve left interest rates unchanged at their policy setting meeting Wednesday, a decision widely anticipated. But in the June update of its quarterly Summary of Economic Projections (SEP), the Fed surprisingly increased its expectations for inflation and unemployment and it reduced its forecast for possible interest rate cuts later this year from three to one. 

That’s a sharp divergence from the consensus view at the beginning of this year. At that point, the markets thought the Fed would cut interest rates seven times in 2024—with the first cut coming this past March—in response to an expected significant decline in the pace of inflation. Our outlook here at Federated Hermes remains for one or two data-dependent cuts after the election. Given the cumulative weight of the central bank’s tightening over the past two years, in which the Fed raised the fed funds rate from zero to a two-decade high of 5.5% and doubled its balance sheet to $9 trillion, we expected that sticky, persistent inflation would grind slowly lower over time. 

Slow motion train wreck? Reflecting these economic trends over the past five months, in which the unemployment rate inched higher, inflation rose, and the economy slowed, benchmark 10-year Treasury yields appropriately increased from 3.80% last December to 4.70% in April. But with inflation softening over the past seven weeks, bond yields have fallen to 4.25%.

Equity investors, however, seemingly looked through this economic and central bank uncertainty, piggybacking the Magnificent Seven’s powerful rally. As a result, the S&P 500 surged nearly 33% from last October’s oversold trough at 4,103 to Wednesday’s overbought intraday record high of 5,447, with stocks up by 14% this year alone.

FOMC meeting results The Fed provided us with the quarterly June update of its SEP yesterday, in which it left unchanged its forecast for GDP growth at 2.1% in 2024 (down from 2.5% in 2023), and 2.0% in each of 2025 and 2026. That’s consistent with our soft-landing thesis. The central bank also left unchanged its forecast for the unemployment rate (U-3) at 4.0% in 2024, exactly where it is now, based upon the May 2024 jobs report. But it increased its 2025 unemployment-rate estimate from 4.1% to 4.2% and its 2026 forecast from 4.0% to 4.1%. 

The Fed increased its estimate for core PCE inflation this year from 2.6% to 2.8%, where it was in April, raised its estimate from 2.2% to 2.3% in 2025, and left unchanged its 2% inflation target for year-end 2026, which is the Fed’s terminal objective. Finally, the policymakers downshifted their intent to implement three data-dependent quarter-point cuts this year to one, followed by four cuts in each of the next two years. 

Inflation has improved

• Nominal PPI wholesale inflation plunged from a record high of 11.7% y/y in March 2022 to 0.8% in November 2023, before rising to 2.3% in April 2023. But yesterday it surprisingly slipped to 2.2% in May. Core PPI inflation (which strips out volatile food and energy inflation) peaked at a record high of 9.7% in March 2022 and plummeted to 1.8% y/y in December 2023, before rising anew to 2.5% y/y in April 2024. But it declined to 2.3% in May.
• Nominal CPI retail inflation plunged from a 41-year cycle high of 9.1% y/y in June 2022 to 3.1% in January 2024, before rising to 3.5% in March. But it surprisingly dropped to 3.3% in May 2024. Core CPI inflation peaked at 6.6% y/y in September 2022 and slowly fell to 4.0% in each of October and November 2023, to 3.9% in both December 2023 and January 2024, and to 3.8% in February and March. But this grinding decline has since accelerated to 3.6% in April and to 3.4% in May. 
• Headline PCE peaked at a record high of 7.1% y/y in June 2022, and has since declined to 2.5% in January and February 2024, before rebounding to 2.7% in each of March and April. The core PCE (the Fed’s preferred measure of inflation) peaked at 5.6% in February 2022 and has since fallen to 2.8% in each of February, March and April 2024. In light of this week’s improvement in PPI and CPI, however, the Bloomberg consensus now expects core PCE to decline to 2.6% in May.
• Average hourly earnings growth peaked at a cycle high of 5.9% y/y in March 2022, gradually declining to 4.1% in May 2024. The Fed needs to see this metric decline to 3% on an annualized basis. Unit labor costs surged by the most in a year in the first quarter of 2024, increasing 4.0% quarter-over-quarter annualized—up sharply from a decline of 2.8% in the fourth quarter. Finally, the Employment Cost Index fell from a cycle high of 1.4% quarter-on-quarter annualized in the third quarter of 2022 to 0.9% in last year’s fourth quarter, before rising to 1.2% in the first quarter of 2024.

Phillips Curve tradeoff Fed officials are trying to navigate two risks at present, given its dual mandate of full employment and low inflation. The unemployment rate is rising, while inflation is receding. That’s exactly what the Fed hoped to see when it began to tighten monetary policy two years ago. But if officials trim interest rates prematurely, inflation may re-accelerate, erasing their progress and allowing inflation to become entrenched at a level above its current 2% core PCE target. But cutting too late risks increasing the unemployment rate more sharply and slowing the economy, potentially pushing it into recession. 

Sahm rule U-3 has risen from its 53-year low of 3.4% in April 2023 to 4.0%. That increase of 0.6 percentage points over the past 13 months has focused attention on the Sahm Rule, which states that if unemployment rises by 0.5% or more on a rolling three-month basis over a year’s time, then the economy typically slows, perhaps into recession. In its SEP update this week, the Fed expects U-3 to peak at 4.2% next year.

Will the November 5 election matter? The Fed prides itself on being apolitical. Over the last eight presidential election cycles spanning 32 years, it has been judicious in changing monetary policy during presidential election years to avoid even the appearance of impropriety. To be sure, if policymakers need to raise or lower interest rates or adjust its balance sheet because of the economy, they will—full stop. But if it’s a close call, and they feel they have the luxury of patience, historically they have tended to abstain from adjusting policy from Labor Day through the election. 

Pushed to the end This year, there are four remaining FOMC meetings on the Fed’s calendar: July 31, September 18, November 7 and December 18. So, with one or two months of better inflation data in the bank, the Fed would like to see that trend lengthen sustainably, which suggests a July cut may be premature. If there’s no economic crisis, we believe the Fed would like to stay on the sidelines in September, given the proximity to the election. That leaves the November 7 meeting (two days after the election) and December 18 as the Fed’s most likely dates to cut interest rates this year. 

Research assistance provided by Federated Hermes summer intern Jake Kavan.

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