In approximately two weeks, I anticipate that the Federal Reserve will raise interest rates, which could have a negative impact on the economy. The intention behind this move is to combat inflation, but it may exacerbate the situation. Let me provide you with a summary of the current economic landscape, including inflation, interest rates, and the overall economy.
First, let’s review how we arrived at this point. Between 2020 and 2022, the Federal Reserve injected a significant amount of money into the economy, amounting to trillions of dollars. This led to a surge in inflation. Now, the Federal Reserve aims to bring inflation back down to its target goal of 2%. Their proposed strategy is to achieve this by raising interest rates. Higher interest rates would slow down economic activity and subsequently alleviate the rapid rise in prices.
For instance, let’s consider the residential real estate market as an example. When interest rates increase, mortgage rates also go up. Currently, the 30-year fixed mortgage rate stands at around 7%. Such a rise in interest rates makes it more challenging for people to afford homes. Consequently, the demand for housing decreases, resulting in a slowdown in home price growth. This concept applies to other sectors as well, such as the automotive industry and small business loans.
It’s important to note that higher interest rates have a broad impact across various sectors, including residential and commercial real estate, the banking sector, business loans, auto loans, and credit card interest rates. Therefore, the Federal Reserve’s decision on interest rates affects the overall economy.
Now, the pressing question is when the Federal Reserve will choose to lower interest rates. In my opinion, they are likely to do so when either of two conditions is met, regardless of which occurs first. First, if inflation falls to acceptable levels, meaning it approaches the target rate of 2%. Second, if an economic event occurs that requires intervention, such as a significant downturn.
To evaluate inflation, we need to consider the measure used by the Federal Reserve, which is PCE core inflation. Currently, PCE core inflation stands at 4.6%. While it may not be declining rapidly, the Federal Reserve’s objective is to bring it down to 2%. Looking at the past five years, PCE core inflation has plateaued around the 4% range, which is higher than the target rate. The Federal Reserve attributes this persistence to wage inflation, emphasizing the importance of the labor market and job reports in their decision-making process.
It is worth mentioning that the Federal Reserve has hinted at raising interest rates at least two more times this year, with the next meeting scheduled for July 26th. If they proceed with a 0.25% increase, it would bring the Fed funds rate up to 5.5%. There is a possibility of further rate hikes in September or November, or potentially both.
On Wednesday, the CPI inflation report for the month of June will be released, and it is expected that the headline CPI inflation will be around 3%. It is crucial to differentiate between headline CPI inflation and the Federal Reserve’s preferred measure, which is PCE core inflation. Despite the headlines emphasizing the lowest inflation in years, the Federal Reserve will still proceed with raising interest rates on July 26th. Their aim is to address the trajectory of inflation towards the target rate of 2%. It is important to stay informed and not be misled by these headlines.
Additionally, we should consider the resilience of the US economy, as reflected in the GDP growth rate. Although it has gradually decreased from 2.6% in the fourth quarter of 2022 to 2.0% in the first quarter of this year, it is still in positive territory. However, two factors require attention. First, the extent to which US consumers can continue propping up the economy if the labor market weakens and unemployment rises. Second, the impending resumption of student loan payments, which will divert money away from discretionary spending and impact retail sales, a significant component of US personal consumption.
The Federal Reserve will potentially lower interest rates if the economy enters a severe recession. The question remains as to which event will occur first: inflation aligning with the target rate, prompting the Fed to cut rates, or an economic shock that forces the Fed to change its course. I will keep you updated on the situation, so please subscribe for further updates. Thank you, take care, and have a great day.