Low core inflation should keep the Fed from hiking rates

REAL ECONOMY BLOG | September 19, 2023

Authored by RSM US LLP

While we expect the Federal Reserve to hold rates unchanged on Wednesday, what its updated Summary of Economic Projections will look like remains less clear.

More likely than not, given the recent robust economic data, we might see higher growth and inflation reflected in the summary along with an easing in the unemployment rate.

That is more in line with a soft landing than an overly hot economy that requires more tightening.

We expect that the Fed’s forecasts for the core personal consumption expenditures index—an important measure of inflation for the central bank—will tick down from June’s number by the end of the year as the central bank looks through the surge in oil prices to focus on underlying inflation instead.

Our model predicts that core inflation will continue to normalize through the rest of the year, running slightly below 0.2% monthly, which is around 2.4% annualized.

That is also equivalent to 3.3% headline year-over-year inflation by year’s end, or 3.5% using the Fed’s comparison to last year’s fourth quarter.

Barring any unexpected shock, core inflation could come down to 2.3% to 2.5% using the above measures by the end of next year. Such a scenario is not too far from the Fed’s ideal scenario where inflation comes back down to its 2% long-term target.

The central bank itself has said that it can tolerate an inflation rate above its target, giving more reasons to believe that the Fed might have done enough to bring underlying inflation under control.

This won’t deter some of the Fed’s members from penciling in higher rate projections in the dot plot, or its interest rate forecast, likely resulting in a median of 5.6% or 5.7%, which means another hike in November or December.

But we should have learned by now not to take those projections at face value. Every meeting will be a live one, and with more economic data coming out before the November meeting, most likely indicating a cooling economy, the Fed will have plenty of opportunities to reassess its position.

How about rate cuts?

It won’t be a surprise if Fed Chairman Jerome Powell will not offer any hint of a rate cut in his news conference on Wednesday while doubling down on having both options of hiking and holding rates on the table for the next meetings.

In either scenario—soft landing or recession—the Fed would have to lower rates no matter what. With our base case that there is a 60% chance of a soft landing, we don’t see a rate cut at least until the second quarter of next year, as long as the Fed does not push the economy into a recession by raising rates.

That means interest rates would and should stay at a multidecade high for at least six more months, enough to slow the economy further.

It is important for rates to remain restrictive as our model predicts a lengthy road for Powell’s key gauge for underlying inflation and wage pressure—the so-called “super-core” that includes core services less housing.

Super-core inflation will most likely run at 0.35% on a monthly average for the remainder of the year, or slightly above 4% on a year-over-year basis. Although super-core inflation often runs above overall and core inflation by a half to a full percentage point, an average of 4% super-core inflation should not provide the Fed any comfort to stay off the brake pedal prematurely.

The takeaway

There is a clear path for a soft landing of the economy that does not require further rate hikes, according to our model. We believe that the Fed’s policy rate is restrictive enough to keep the economy cooling without any unexpected turbulence.

A rate shock is the last thing the economy needs. If the Fed remains true to its recent mantra of being data-dependent, it should stay patient to take in the totality of the data to safely land the plane.