The Federal Reserve’s Federal Open Market Committee (FOMC) Will Meet This Week and Ask: “Are We There Yet?”

The answer is that monetary policy is so restrictive that the Fed could justify lowering policy rates. The Fed’s preferred inflation metric, core PCE (which measures consumer prices excluding food and energy components), is now rising at a yearly pace of +2.9% (December 2023), down from a peak growth pace of +5.6% (February 2022). The significant difference between core PCE and core CPI (Consumer Price Index) is that the former weights the price components based on the changing preferences of consumers. Suppose the price of strawberries rises and individuals switch to consuming more blueberries. In that case, blueberries will be weighted more heavily (when constructing the price index) as the shift in demand occurs.

The spread between the federal funds rate and the yearly rise in the core PCE has been at its most expansive levels since October 2007, or 66% higher than its historical average. Although this gives the Federal Reserve enough leeway to cut policy rates, the more salient question is whether it needs to. Real GDP for Q4 2024 rose by +3.3% or about 85% above the economy’s regular potential growth rate. With such growth rates, it is like asking a motorist whether they should stop and fill up their gas tank after driving for a long time at the first sign of a gas station. The obvious answer is that motorists will be motivated to stop and fill up only if they are close to running out of gas. That means that if the vehicle runs more efficiently due to higher gas mileage (a.k.a., the economy is thriving), the motorist/Fed may not need to act!

Source: The Federal Reserve and the Bureau of Economic Analysis

Are We There Yet?

Others might say, “Wait a minute! The Fed’s goal is to bring the core PCE inflation rate to a yearly growth pace of +2.0%, and at +2.9%, inflation is still running hot.” Yes, that is true, but when you look at the 6-month and 3-month annualized growth rates, core PCE is rising at a yearly pace of +1.9% and +1.5%. That means the Fed has already accomplished its +2.0% goal on a 3 and 6-month annualized basis!

Source: The Bureau of Economic Analysis

It should come as no surprise that the spread between the federal funds rate and the 6-month annualized growth rate in core PCE is now more than double its historical average. A similar result is generated using the spread between the federal funds rate and the 3-month annualized core PCE growth rate!

Source: The Federal Reserve and the Bureau of Economic Analysis

Source: The Federal Reserve and the Bureau of Economic Analysis

We leave it up to the reader to decide whether the Fed’s job will be done only after the core PCE is down to +2.0% on ALL three metrics, namely, on a yearly, 6-month, and 3-month annualized basis. Still, others may wish to be even stricter and say that the Fed should keep depressing the economy until prices are lower to compensate for the prior inflation excesses, even though these criteria have never been applied to any global central bank! During a recent in-person client presentation, one participant chuckled and told me that if this causes a significant recession, we can always blame the current administration or the central bank!

Why is the Federal Reserve Being So Cautious?

The Federal Reserve remembers the inflation battle that Paul Volcker experienced during his tenure (August 1979 -August 1987). In April 1980, Volcker began lowering the Fed funds rate from 17.6% (April 1980) to 9.0% (July 1980), only to see the CPI drop only from +14.6% to 13.2%! That was a crushing disappointment, causing the Fed to push the Fed funds rate back to 19% (July 1981)

It is interesting to hear so many complaints about the Fed today (with a 5.3% federal funds rate) because the CPI peaked at 9.1% (June 2022) and is down only 2.9% (Dec. 2023). I lived through this period, and if I had a time machine, I could show everyone that back in 1981, if people had observed the CPI rising by 2.9%, they would have invited their favorite high school marching band to celebrate!

Source: The Federal Reserve and the Bureau of Labor Statistics

Summary and Concluding Thoughts

The Fed critics are more assertive today than during the 1980s, even though we all agree that if inflation slows to a +2.0% growth pace, it will not reverse the +9.1% growth pace recorded in June 2022. Imagine if Argentina’s central bank, overseeing a +211% yearly inflation rate (December 2023), was asked to keep its monetary policy restrictive until its prior inflation rate was reversed!

Nothing is wrong with demanding more, but we should never forget history and realize that the Fed is doing better today using the judging criteria employed 50 years ago.

It is amusing that, with an economy registering a +27.9 trillion-dollar nominal GDP figure in Q4 2023, we get upset if the CPI was +0.1% higher than the market expected! The range of errors in all these estimates is so high that no one should be surprised if the correct figure were +0.2 or even -0.2 %!

The only sure thing is that the yearly CPI growth rate of +2.9% (Dec. 2023) is much lower than the +14.6% (April 1980) figure. That means we should acknowledge that as bad as our inflation growth rate might seem today, it is significantly lower than what we witnessed 43 years ago under Paul Volcker, who was widely respected for his inflation-fighting credentials!