Weekly Economic Outlook — Jul 20: With Fed Divisions and Murky Data, What Is the Likely Path for Rates?

Analysts are closely watching the Federal Reserve ahead of its next meeting, the second under its new leadership. A departure from the explicit “forward guidance” policy of the previous era has reintroduced a significant degree of market uncertainty, forcing observers to weigh conflicting signals on the future path of interest rates. A rate cut would be a major surprise, and while futures markets are pricing in a small probability of a rate hike, a decision to hold rates steady appears to be the most likely outcome.

THE CASE FOR A RATE HIKE

Arguments for a rate increase persist. The Fed’s last “dot plot” survey in mid-June revealed a hawkish tilt among some members, with nine of the nineteen policymakers projecting at least one rate hike this year. Furthermore, the new Fed chair has stated a “no tolerance” policy for inflation exceeding the 2% target, a benchmark that has not been met in more than five years. This raises questions about the central bank’s credibility and when, if ever, it intends to bring inflation back to its long-term goal.

Economic data also provides ammunition for monetary tightening. Nominal GDP has expanded at a 5.4% annual rate over the past two years and a 6.1% rate since the fourth quarter of 2019. Historically, the 10-year Treasury yield tends to align with nominal GDP growth over the long term. Given that the federal funds rate has, over the past 50 years, averaged about 1.15 percentage points below the 10-year yield, current growth rates could imply a higher equilibrium interest rate than the current 3.625%.

THE CASE FOR PATIENCE

However, several factors support a patient, wait-and-see approach. Recent inflation data has been murky, with geopolitical conflicts in the Middle East and Ukraine contributing to volatile energy prices. Bond market indicators suggest long-term inflation fears may be contained, as the five-year forward “breakeven” inflation rate currently stands at approximately 2.4%. This suggests that while inflation is elevated, investors expect it to moderate closer to the Fed’s target over time.

While strong nominal GDP growth seems to argue for higher rates, some analysts question its underlying strength. Significant investment in data center construction may be inflating the headline growth figure, much as the dot-com boom did in the late 1990s and the housing market did in the mid-2000s. Excluding this temporary surge in investment, the underlying economy may be weaker, warranting a more cautious stance on interest rates.

BEYOND INTEREST RATES

Fed leadership has also signaled a focus on tools other than the federal funds rate to combat inflation. One prominent tool is the management of the Fed’s balance sheet, a process known as Quantitative Tightening (QT). By trimming its asset holdings, the central bank can reduce liquidity in the banking system, which helps to constrain the growth of the money supply and, by extension, inflation. This focus is supported by recent data showing that the M2 measure of money supply has grown at a modest 4.7% annual rate over the past two years. Ultimately, sustained inflation is unlikely without a significant acceleration in money supply growth.

A SHIFT IN INFLATION FOCUS

Further evidence for a hold comes from a potential shift in how the Fed analyzes price pressures. There is notable interest in focusing more on “trimmed-mean” inflation rates. This methodology excludes the most volatile price changes in any given month, providing a clearer view of the underlying inflation trend by looking at what prices in the middle of the distribution are doing. With housing inflation—a major component of consumer price indexes—already showing signs of significant moderation, this alternative metric could provide further justification for holding rates steady.

Taken together, the evidence suggests a strategic pause is the most probable course of action. The new leadership appears to be navigating internal divisions and external political pressures by building a case for patience. By emphasizing alternative inflation-fighting tools and questioning the quality of headline economic data, the central bank can delay further rate hikes while it works to consolidate its policy direction and await a clearer economic picture.

Key terms:

1. **Quantitative Tightening (QT):** A monetary policy tool where a central bank reduces the size of its balance sheet by selling or not reinvesting the proceeds from maturing government bonds and other assets. This action decreases the money supply and raises borrowing costs, aiming to cool down an overheating economy and curb inflation.

2. **Trimmed-Mean Inflation:** A measure of core inflation that excludes a certain percentage of the highest and lowest price changes in a given period. It is intended to provide a more accurate reading of the underlying inflation trend by removing outlier price movements that can skew the data.

3. **Dot Plot:** A chart published quarterly by the Federal Reserve that shows the anonymous projections of each of the 19 FOMC members for the future path of the federal funds rate. It provides insight into policymakers' expectations but is not an official policy commitment.