Economic data showing continued muted U.S. inflation, along with the expectation of a slowdown in U.S. growth, have helped fuel forecasts for a Fed rate cut. The odds for a cut to come in July have reached more than 65%; for September, nearly 50%, according to the CME FedWatch Tool.
But before settling in with those expectations, investors might want to consider more closely the factors affecting growth and inflation.
For example, in a recent report, National Bank’s Krishen Rangasamy highlighted positive economic data from U.S. small businesses “keen to increase employment and wages amid labour shortages.” Nearly one-third (30%) of respondents to the latest business optimism index of the National Federation of Independent Business said now was a good time to expand—the highest proportion this year.
The measure is “highly positively correlated with the fed funds rate,” the report said. “All told, the market’s call for looser monetary policy is not consistent with the latest data from small businesses.”
Recent comments from Derek Holt, vice-president and head of capital markets economics at Scotiabank, also dampen expectations for a rate cut, at least for this month. In a report, Holt said the case for the Fed to shed stronger easing at its upcoming meeting got stronger with the latest inflation data.
With core inflation (core CPI) in May increasing a slight 0.1% month over month and 2% year over year, the Fed’s preferred inflation gauge, core PCE, could see further downward pressure, he noted. Core PCE is typically lower than core CPI, and was 1.6% year over year in April.
If it drops 0.1% to 1.5% in May, it would be at the “trigger point to get more worried about undershooting the Fed’s inflation objective,” Holt said, based on comments from the Chicago Fed’s Charles Evans.
However, concerns about downward pressure on core PCE could be overblown.
For example, a report published today by CIBC noted that one factor recently making a relatively large contribution to the slowdown in core PCE—portfolio management fees—has normalized in recent months.
Last year, surging portfolio management fees contributed to a historically small difference between core PCE and CPI, the report said. That’s because these fees are part of core PCE but not core CPI. Now, the difference between the two measures is more akin to average.
Thus, the weakening in core PCE “simply reflects the return to a more normal gap,” the report said.
Further, the underlying trend in inflation hasn’t really weakened over the past year, the CIBC report said, according to different measures of underlying inflation from various regional Fed economists. In fact, on average, these alternative measures show inflation is a bit higher than a year ago.
Still, the measures are mostly lower compared to where they stood on average before the Great Recession.
The report also noted that expectations for low inflation act as a self-fulfilling prophecy; therefore, a case could be made for reducing interest rates to boost inflation expectations.
Also consider that, while core PCE readings of about 1.5% “don’t scream for immediate interest rate cuts,” they provide the Fed with room to manoeuvre should U.S.-China trade tensions persist or escalate, the CIBC report said.
As the Fed decides its next move, an AGF blogpost looked to the past for historical context—specifically to the ’90s.
“The Federal Reserve found itself in a similar position in the mid-to-late 1990s despite facing much different issues, notably the collapse of hedge fund Long Term Capital Management and the Asian financial crisis,” said Kevin McCreadie, CEO and CIO at AGF Management Ltd., in the post.
Starting in February 1994, the Fed raised rates six times before cutting three times in the second half of 1995 and early 1996, raising once more in 1997.
“From there, the Fed changed course again, cutting rates three more times in 1998, which ultimately helped fuel the dot-com frenzy and led to the market collapse in 2000,” McCreadie said.
Investors today aren’t likewise gripped with irrational exuberance, he said, but “there’s every chance that equity markets could rally higher if Mr. Powell does as is widely expected and cuts rates starting in September.”