The Fed's Potential Rate Cut Amidst Stubborn Inflation: A Closer Look

Even though inflation remains stubbornly around 3%, a full percentage point above the official target, markets widely expect the Federal Reserve (Fed) to cut interest rates at its next meeting. This scenario raises a crucial question: is the 2% inflation target still a viable goal, or are we witnessing a shift in economic dynamics?

Recent Inflation Data and Monetary Policy Challenges

Data expected to be released on Thursday is projected to show the core CPI annual rate rising to 3.1% in August. This metric, favored by the Fed, rose 2.9% year-on-year in July. Easing monetary policy at this level of inflation is considered an unusual move. Admittedly, the Fed did cut rates late last year when core CPI was even higher (around 3.3%), but that action sparked considerable debate. Unemployment did not rise as Fed officials warned, and long-term Treasury yields actually climbed. To find a precedent for the Fed easing policy when core PCE inflation was at 3%, one must go back to the early 1990s, before the Fed informally adopted the 2% target.

A Changing Economic Landscape

The 1990s were a drastically different economic era. The internet was not widely adopted, smartphones did not exist. Therefore, the Fed easing policy a second time in a year with core inflation at 3% is a significant event. It may signal that the economic orthodoxy of recent decades is facing a challenge or even a disruption.

Inflation Concerns and Market Response

There are still hawks within the Fed who are more concerned about the inflation outlook. Additionally, with US federal government debt and deficits at historically high levels for a non-crisis peacetime, long-term Treasury yields could climb again. However, financial markets do not seem overly concerned. Of course, inflation concerns are reflected in the prices of some assets, most notably gold. Gold prices are up nearly 40% this year, reaching new all-time highs almost daily. However, looking around, it is difficult to argue that financial markets are overly worried about the Fed abandoning the 2% target. In fact, the 2-year/30-year Treasury yield curve has steepened by about 70 basis points this year, hitting a four-year high of 134 basis points last week, but the 30-year Treasury yield has actually fallen slightly this year. At the same time, US corporate bond spreads are at historic lows, and Wall Street continues to reach new record highs.

Consumer Expectations and Inflation

Academic research suggests that consumers are the least accurate in predicting inflation, but policymakers have long been hesitant to disregard their influence. Currently, 2% is no longer within the range of consumer inflation expectations. A New York Fed survey released on Monday showed that consumer expectations for one-year inflation rose in August from 3.1% in July to 3.2%, while three- and five-year inflation expectations remained stable at 3% and 2.9%, respectively. The latest University of Michigan survey showed one-year and five-year expectations at 4.8% and 3.5%, respectively.

Is 3% the New Target?

Perhaps 3% is replacing 2% as the new inflation target. Given that President Trump clearly wants to overheat the economy, he obviously supports this trend. And the Fed seems prepared to ease policy again in a 3% inflation environment, setting aside inflation risks.

Is This a Mistake by the Fed?

Not necessarily. Jim Paulsen, a longtime Wall Street bull and former chief strategist at the Leuthold Group, questions the "continued hysteria" over inflation overshooting the target. To break the "2% target delusion," Paulsen points out that the average annual CPI over the past two years has been 2.9%, and is currently just 2.7%. Isn't that price stability? He also points out that the average annual CPI from 1992 to 1999 (often considered an "economic paradise") was 2.6%. "It's time to retire the 2% inflation target. We have consistently included smart, pragmatic, and experienced economic experts on the Federal Open Market Committee (FOMC). They should be allowed to act on their professional judgment, rather than being constrained by an arbitrary target that has not been sufficiently verified," Paulsen wrote on Monday. If Thursday's inflation data reaches 3%, and then the Fed cuts interest rates next week, it may be a sign that we are moving in that direction.