Fed Set to Cut Despite Inflation Pickup

How Will Powell Describe Move?

SriKonomics has repeatedly emphasized that the premature, and sizable, interest rate reductions by the US Federal Reserve in recent months will inevitably lead to an acceleration in inflation. Such a discussion is of more than academic interest. A pickup in inflation would lead to higher yields on long-dated Treasurys and mortgages, and slow economic growth — going against Treasury Secretary-designate Scott Bessent’s objective of achieving 3% economic growth.

Higher interest rates would also attract funds to the United States from the rest of the world, contributing to a stronger dollar and reduced export competitiveness. Simply put, higher inflation rate would have no desirable consequences.

After having reduced the Federal Funds rate by an unexpectedly large 50 basis points in September, and by another 25bp last month, the US central bank is finding the inflation data far from encouraging. Consumer Price Index data released by the US Bureau of Labor Statistics on Wednesday showed that year-on-year inflation rose to 2.7% in November from 2.4% in September and 2.6% in October. While the headline measure kept rising, inflation in core CPI (which excludes food and energy) stayed stubbornly at 3.3% for the third month in a row. Core inflation had been running at a 3.2% annual rate in July and August. The Fed’s target is 2%.

Especially noteworthy was that the cost of shelter (rent) that had been a major component of inflation in recent months slowed from 0.4% month-on-month in October to 0.3% in November. But details of the CPI numbers showed that essential items that account for a large portion of low- and middle-income wage earners’ spending experienced some of the most pronounced increases. Inflation in the “food-at-home” category (groceries) surged month-on-month from 0.1% in October to 0.5% in November. “Four of the six major grocery store food group indexes increased in November” the BLS report points out, with the index for eggs up 8.2% just over the month.

There was no relief in the Producer Price Index published on Thursday either. Annual PPI inflation was stuck at 3.4% for the second successive month, accelerating from 3.2% in September and posting the fastest price increase since February 2023. On a month-on-month basis, the inflation rate was 0.4% last month, up from an upwardly revised 0.3% in October.

Despite their repeated protestations of being apolitical, Federal Reserve Chairman Jerome Powell and his colleagues ought to know that the import tariff increases threatened by President-elect Donald Trump will result in further inflationary pressures even if the levies are only partially implemented. Would such concerns lead policy makers to pause next week and delay making the next downward rate move after implications of the Trump measures become clear? Unlikely. Illogical as it may seem, Powell may well conclude that anticipation of the moves would imply an explicit movement by the Fed into the political arena.

Despite uncertainty on the inflation front, markets place a near-100% probability of the Federal Open Market Committee lowering the policy interest rate by another 25bp on December 18. Given that Powell does not like to disappoint markets and cause a recession, the FOMC will likely go along with the market expectations. What reasons is the Chairman likely to provide for ignoring the rise in inflation and continuing to reduce rates?

First, a term that has become a favorite of the US central bankers is that inflation is likely to be “bumpy” in its descent toward the 2% target. Should the persistence of inflation at higher levels, and even increases, still be considered just a bumpy process? Don’t expect the Powell post-FOMC press conference to provide anything like a convincing answer.

Second, after seven successive weeks of declining initial jobless claims, the figure jumped up to 242,000 in the latest week, roughly matching the level during the week of October 12. If the Chairman mentions this as the reason for continuing to lower rates, he needs to be reminded that the jobless claims figure has been on a declining trend after the recent high in early October. Someone who ignores the repeated failure to achieve inflation targets should not be able to use a one-time elevated jobless figure to justify a rate reduction.

Third, we have Powell’s repeated statements that the Federal Reserve has the tools to shift policy if inflation turns out to be too hot. In reality, it does not have the necessary instruments to make adjustments without putting the economy through through the wringer. Sharp interest increases by the Fed to counter historically high inflation in the late 1970s led to the painful recession of 1981 - 1982 which was necessary to correct the previous excesses of policy.

More recently, the Fed’s erroneous prediction of “transitory” inflation from covid-related supply bottlenecks led the central bank to double its balance sheet in just two years (January 2020 - January 2022) accompanying a sharp increase in fiscal spending by the Treasury. The combination seriously dented the purchasing power of lower income groups and was a key factor in the current administration losing the November elections. This story is still playing out.

The FOMC has a major decision to make at its meeting on December 17 - 18. It could pause on interest rate cuts and cause a sizable correction in equities because they had depended on benevolent Uncle Jay to perennially provide a put. Alternately, they can meet market expectations and cut interest rates by another 25bp, and propel both equities and inflation upward.

After reading this note, you know which alternative I think Powell and his colleagues will choose!

Dr. Komal Sri-Kumar

President, Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

December 14, 2024

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