Fed chair gives strongest hint yet about when rate cuts will begin

The Fed’s preferred measure of inflation fell to more than three-year lows in May
By Sam Bourgi
•
12 July 2024
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Fed chair Jerome Powell didn’t have to set any timeframes to send his strongest signal yet that rate cuts are on the horizon.

In his second day of congressional testimony on Capitol Hill, Powell made the bombshell remark that the Fed will not wait for inflation to get back 2% before slashing interest rates.

“You don’t want to wait until inflation gets all the way down to 2%,” Powell said. “If you waited that long you probably waited too long because inflation will be moving downward and would go well below 2%, which we don’t want.”

Although most Americans are familiar with the Consumer Price Index (CPI), the Fed’s preferred measure of inflation is the core Personal Consumption Expenditures (PCE) index.

In May, the annual core PCE index fell to 2.6%, the lowest since March 2021.

That’s not terribly far from the Fed’s long-held, albeit controversial, 2% target. It’s also a big improvement from one year earlier when core PCE ran at a multi-decade high of 4%.

“We look at different measures, but for a quarter of a century, the PCE inflation has been the Fed’s goal,” Powell explained. “We define our goal in terms of that because we believe it is the better measure of the cost of inflation that the public faces.”

What about neutral rates?

In his congressional testimony, Powell also touched on the subject of “neutral” interest rates. For the Fed, the neutral interest rate is the point at which monetary policy neither stimulates nor restricts economic growth.

Although measuring the neutral rate isn’t an exact science, Fed officials put it at around 2.5% after the pandemic. They’ve raised that estimate to 2.8% since, with Powell suggesting it could go even higher.

“Clearly, the neutral interest rate must have moved up, at least in the short term,” he said.

The Fed’s estimate of the neutral rate provides a guidepost for how low interest rates can go when inflation is back to normal. If inflation falls further, the Fed will likely target that rate in future policy decisions.

Even if the Fed deems the neutral rate at 3%, that still leaves plenty of room for rate cuts. The federal funds rate currently sits at 5.5%, the highest in more than two decades.

This outlook may partly explain Citi’s recent forecast calling for eight consecutive rate cuts, beginning in September. The bank’s analysts also cited the possibility of a recession as a reason for aggressive cuts.

“A continued softening of activity will provoke cuts at each of the subsequent seven Fed meetings, in our base case,” they said.

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