Yesterday, for the first time in more than a year, the Federal Reserve Open Market Committee, which sets the nation’s benchmark interest rate, voted not to raise interest rates at a regular meeting. But that doesn’t mean the cycle of rising interest rates is over; it simply signals that the central bank is taking a “pause” (to use Chairman Jerome Powell’s expression) to see whether the stiff rate increases already imposed can succeed in bringing inflation down to the Fed’s 2% target. In that context, Tuesday’s inflation report was modestly encouraging.
By any historical measure, the recent pace of interest rate increases has been stunningly swift. As recently as early 2022, rates were close to zero; now they are just above 5%. None of the previous rate raising cycles in the last 40 years have been remotely as fast. Wednesday’s pause does not, however, mean that rates have reached their peak. Financial markets see a 94% chance of a 0.25% increase in July. And Mr. Powell said that not a single member of the 12-person FOMC envisions a reduction in rates this year.
Indeed, as part of today’s meeting, the Fed also released updated projections for both interest rates and the overall economy. On interest rates, FOMC members have become a bit more pessimistic, envisioning a federal funds rate of just over 5.5% at the end of the year, which would imply two more hikes. And while the FOMC does see rates declining in 2024, financial markets see significantly steeper declines. As for the economy, the central bank has become somewhat more optimistic about economic growth, projecting 1% expansion for this year, compared to the 0.4% forecast in March. With that, it expects slightly lower unemployment and slightly higher inflation than its previous forecast.
As has been the case for many months, the key driver of Federal Reserve policy is likely to be inflation. In that context, Tuesday’s report was helpful. The “headline” increase in the Consumer Price Index dropped to 4.1% from 5%, both compared to a year earlier. “Core services,” a narrower measure highlighted by the Fed – which excludes volatile categories like food and energy, as well as commodities and housing – rose by 4.6%, compared to 5.1% last month. While these are both good results, by any measure, the pace of price increases remains well above the Fed’s 2% target. (Note that housing costs continue to rise by about 8%, but this figure should decline as the impact of higher mortgage rates continues to take hold. And goods prices, which had driven much of the early inflation surge, rose by only 2% compared to a year earlier.)
The future path of inflation will be affected by a number of factors. Perhaps the biggest will be the pace of labor cost increases. While higher wages are generally considered desirably, they can also push prices up. In that context, the pace of employment cost increases has moderated slightly from their peak last spring. However, at just over 5%, they remain far above the Fed’s 2% price target. (They would need to come down to between 3% and 3½% to be consistent with 2% inflation.) With employers still having trouble filling open jobs – there are 1.8 open jobs for every American looking for one – it’s unclear when the rate of wage increase might moderate further.
Another reason for persistent inflation is that companies have been able to pass along to customers the vast bulk of their increased costs. One way to measure this is by looking at corporate profits – if companies were absorbing these cost increases, it would be reflected in their net income. But profits have risen sharply as inflation has soared, even adjusted for inflation, profits remain near record levels. Another measure – profit margins – have also remained robust, at 15.7%. While this is down from 16.9% in the third quarter of 2022, it’s well above the 12% pre-pandemic average.