Mid-Year Economic Update – Whither the Fed?
As we approach the mid-year point of 2024, economic indicators continue to show a strong and resilient U.S. economy. In its June 11-12 meeting, the Federal Reserve’s Open Market Committee (FOMC) kept the target range for the Fed Funds rate at 5.25% to 5.50%. They noted that potential rate changes were on hold while the “economic result is uncertain, and the Committee remains highly attentive to inflation risks.” In addition, they continue to reinforce that they are “strongly committed” to returning inflation to its 2% objective and that they “would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee’s goals.” As we all know, the Committee’s goals are focused on maintaining long-term inflation at a rate of 2% while achieving maximum employment. By carefully assessing these two goals and the current economic environment, it may be possible to have some understanding of the Fed’s decision-making process.
The Fed’s Dual Mandate: Long-run Inflation of 2%
The May Consumer Price Index for All Urban Consumers (CPI-U) was unchanged from April on a seasonally adjusted basis, and it was up 3.3% over the last 12 months before seasonal adjustment, down from 3.4% in April. A decline in the price of gasoline, which was down 3.6% in May, and an overall decline of 2.0% in energy prices helped offset increases in the price of shelter, education, medical care and used vehicles. In addition to lower energy prices, several other categories of items decreased in price in May, including new vehicles, apparel, communication and transportation services (auto repair, auto insurance and airfare). This slight easing of inflation moves us one more step, albeit a small one, towards the Fed’s 2% target rate.
With inflation continuing to moderate, Fed watchers continue to speculate why the Fed has remained reluctant to begin easing monetary policy. A perhaps-underappreciated factor that may be important to understanding the way the Fed views inflation involves the impact of expected inflation on the real economy.
The Fed adopted 2% as a policy target in 2012. As shown in the following chart, inflation remained stable and near 2% from January 2012 until March 2021. Since that time inflation has remained persistently above the Fed’s 2% inflation target.
Consumer Price Index for All Urban Consumers: All Items in U.S. City Average
Source: U.S. Bureau of Labor Statistics; fred.stlouisfed.org. Shaded areas represent U.S. recessions.
This presents two problems for the Fed. First, it violates one of the Fed’s twin mandates (stable prices) that they have explicitly targeted as 2% inflation over the longer run. Second, and similarly important from the Fed’s point of view, is that a persistently steep rise in the price level increases the likelihood that higher-inflation expectations become embedded in people’s minds. If people believe that higher inflation will continue further into the future, then firms will take that into account when setting prices and workers will demand higher wage increases. In this way, an expectation of future inflation becomes somewhat of a self-fulfilling prophecy. Thus, the Fed will do everything in their power, not only to bring inflation under control, but to ensure their commitment to such a policy is clearly understood by the populace to prevent inflation expectations from getting out of control and sparking actual inflation on its own.
The Fed’s Dual Mandate: Maximum Employment
The second part of the Fed’s dual mandate is to achieve maximum employment. As noted in the Fed’s press release on June 12, “job gains have remained strong, and the unemployment rate has remained low.” The U.S. Bureau of Labor Statistics’ May Employment Situation Survey reported that the unemployment rate edged up slightly to 4.0% from 3.9% in April, while nonfarm payrolls grew by 272,000 in May, up from 180,000 in April. In addition, average hourly earnings increased 4.1% year-over-year. While there is clearly a juxtaposition between a rise in the unemployment rate and an increase in nonfarm payrolls, there are a couple of possible culprits for the seemingly divergent statistics. The first explanation may be that the workforce simply expanded in May given a combination of immigration and idled workers returning to the workforce. There is also a possibility that the survey data used in these two measures may, at times, not present a full picture of the reality of the employment environment.
Unemployment Rate
Source: U.S. Bureau of Labor Statistics; fred.stlouisfed.org. Shaded areas represent U.S. recessions.
Despite the rise in the unemployment rate, if we view the current labor market in context of recent history, employment in the U.S. economy still seems to be strong. The chart above shows the historical unemployment rate in the U.S. from January 1970 through May 2024. If we just look at the period from January 1970 through April 2018 (580 months), the unemployment rate averaged 6.3%. Out of those 580 months, the unemployment rate fell below 6.3% a total of five months, or 0.9% of the time. Since then, the unemployment rate has averaged 4.7%. Using the past 54 years as a guide, and despite the recent uptick in the unemployment rate, the U.S. employment market remains strong.
Where do we go from here?
Fed Chairman Jerome Powell has been consistent in reiterating that the Fed’s decision-making process would be “data dependent.” It may be wise to assume that until inflation cools enough so the Fed becomes comfortable that inflation and inflation expectations have been tamed, or until the employment market cools enough that unemployment begins to exceed what the Fed might consider maximum employment, there will be little policy change. In addition to these sometimes-competing policy goals, the Fed seems to be keenly aware that while inflation is moderating, it’s more of a hardship on those with middle- and working-class incomes. In his June 12 press conference, Chairman Powell noted that he and his colleagues “are acutely aware that high inflation imposes significant hardship as it erodes purchasing power, especially for those least able to meet the higher costs of essentials like food, housing, and transportation.” As such, slaying the inflation dragon remains a high priority for the Fed, but doing so without weakening economic activity or employment will remain a tricky needle to thread.
As investors, it may be wise to heed the Fed’s counsel and remain “data dependent.” Forecasting the complex relationships and feedback loops among the various economic measures and coming up with a directional policy is something the Fed, despite their army of economists, seems loathe to do. In our view, following this lead and building your portfolio based on your long-term needs, goals and risk profile should be a guiding principle of investing. By doing so, you should be prepared for the various economic and market scenarios that may occur, while maintaining the ability to adjust to risks and opportunities as economic and market data change.
ABOUT THE AUTHOR
Greg Bone
Greg is a Partner, Investments Leader in our Dallas office. He joined legacy firm RGT team in 2002. All told, he has more than 20 years of experience in portfolio management and investment research. Greg previously served as a portfolio manager at H.D. Vest and has considerable experience in both graduate and postgraduate economic research.
Greg received his Bachelor of Arts in Economics from Hendrix College and holds a master’s in economics from Southern Methodist University. He holds the Chartered Financial Analyst® designation.
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