The Fed raised its policy rate by 25 basis points this week. This most recent hike, coupled with relatively tame reports of inflation, led to some hopes that monetary tightening may now be over. It’s probably not.

In Focus - A Summer Dip

This impatient cry will be familiar to any veteran of summer car trips: “Are we there yet?” Last week, in the context of the Fed’s program of monetary tightening, there was particular eagerness to think that we’ve arrived.

In the end, the Fed hiked the target Federal Funds rate by 25 basis points above where the dashed line ends on the chart, to a new target range of 5.25-5.50%. In the accompanying statement, the Fed said it would keep a close watch on developments to see how much “additional policy firming… may be appropriate to return inflation to 2 percent over time.” That 2% target is the straight red line on the graph.

In the surrounding public commentary, there were two themes offered to support the conclusion that the destination of this tightening cycle is near:

1. We’ve seen a dramatic fall in inflation, from 9% to 3%. That means we’re almost at 2%.

2. The Fed’s rate hikes have been dramatic – a 22-year high in rates! Surely that should suffice.

The themes are, at best, misleading. We’ll take each in turn.

How much has inflation actually fallen? The drop in the headline Consumer Price Index (CPI) has been extreme. That’s not the best inflation measure for Fed decision-making, however. The CPI swoon was heavily influenced by food and energy prices, which becomes clear when they’re excluded from CPI to leave Core CPI. That’s shown by the seafoam green line in the chart. The descent in Core CPI is indisputable, but far less satisfying. The series had a recent peak at 6.6% in September 2022 and in June was down to 4.9%.

The Fed’s preferred inflation gauge, the core version of the Personal Consumption Expenditure (PCE) deflator, was just refreshed this week. That’s the solid dark line in the chart. It was 5.2% back in September 2022 and dropped to 4.1% in June.

The core inflation measures are all telling a similar story: inflation is starting to drop; we’re off the highs of last year; we’re far from 2%.

But turning to the second theme of the week: Can’t we be confident that the extreme sequence of rate hikes already implemented will do the job?

It hasn’t been that extreme, so no. The relevant consideration for interest rates is the real, not nominal figure. The nominal figure (as shown in the chart) has the appeal of being more transparent. One gets a real Fed Funds rate by subtracting the inflation rate. But there’s room for argument about which inflation rate. Even the core inflation indices shown in the chart can be pretty far apart.

Fortunately, we can take a visual short cut with the graph. How long has it been since we saw the Fed Funds rate a bit above core inflation measures (one version of a positive real interest rate)? We saw it in the spring of 2019. It’s not a 22-year novelty.

The Fed has another tool it’s employing as well – reducing the size of its asset holdings. On the eve of the pandemic recession, it held $4.2 trillion in assets. They peaked in May 2022 at just under $9 trillion. As of this last week, they were down to ‘only’ $8.2 trillion. Hardly extreme quantitative tightening.

Fed Chairman Jay Powell, at his press conference last week, spelled out the implication of all this: “the process of getting inflation back down to 2 percent has a long way to go.”

We’re not there yet.

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Economic Developments

Real U.S. GDP expanded at an annualized rate of 2.4% in Q2, up from a reading of 2.0% in Q1, mainly due to rises in private investment, which increased from -11.9% in Q1 to 5.7% in Q2. Final sales to private domestic purchasers slowed to 2.3% in Q2 from 3.2% in Q1, showing a strong but subsiding consumption engine for growth.

U.S. 12-month trimmed-mean PCE inflation rate was 4.2% in June, a fall of 0.4 percentage points from May. That was the lowest reading since May 2022. Both trimmed-mean and core PCE inflation (see essay) are particularly important in Fed decision-making.

U.S. real personal consumption increased 0.4% month-on-month in June up from May’s reading of 0.1%. Spending on goods overall in June expanded by 0.9% month-on-month after a 0.2% contraction in the previous month. Durable goods propelled the increase with a 1.7% rise from May to June, and nondurable goods also went up by 0.4%. Real disposable personal income also increased, but at a slightly lower rate of 0.2%.

Advance wholesale inventories in the U.S. fell 0.3% from May to June, while retail inventories increased by 0.7%. Compared to June 2022, wholesale inventories were still up 1.7% and retail inventories were higher by 5.4%. These numbers are adjusted for seasonality and trading day differences, but not for inflation.

Real German GDP in Q2 showed flat (0%) quarter-on-quarter growth after two consecutive quarters of contraction. In the face of ECB interest rate hikes, the modest rebound in GDP growth can be attributed to strengthened consumer spending. Q2 GDP is still 0.2% below the level of the same quarter in 2022.

Euro area consumer sentiment declined for the third month in a row, falling by 0.8 points to 94.5 in July. Consumer confidence in retail trade increased but was offset by persistently weakened confidence in industry and construction.

Mexico’s June exports of manufactured goods were up 0.2% from May and 2.7% above the same period last year. Despite a 4.6% month-on-month fall in June, auto exports were up 9.5% from the same period in 2022. Total non-oil exports to the US grew 2.7% from June 2022. Imports of intermediate goods increased by 2.8% month-on-month but were down 8.4% year-on-year.

A Dutch analysis found World Merchandise trade rebounded in May with a 0.3% month-on-month increase after a 1.6% decrease in April. Momentum in world trade, a measure of the current three-month period over the previous three months, was 0.7%, up from April’s reading of 0%. The improvement was driven by an 11.8% increase in imports and 7.4% rise in exports from emerging Asia ex-China.

The IMF updated its World Economic Outlook, revising upward its initial April predictions for global growth in 2023 by 0.2%, now estimating an annualized rate of 3.0%. This improvement came amid concerns of historically weak growth due to central banks repeatedly raising policy rates, as well as geopolitical and extreme weather-related risks. World trade volume growth projections for 2023 were revised downward from April estimates by 0.4% to an annualized rate of 2.0% but upward by 0.2% to a rate of 3.7% in 2024. Forecasts for core inflation rose by 0.3% for 2023 and 0.4% for 2024 over previous estimates, suggesting a longer fight for central banks to hit their targets.

Political Developments

The ECB raised its three key interest rates by 25 basis points last week, the 9th consecutive increase since July 2022. ECB president Christine Lagarde noted that while previous rate hikes are pushing prices down, inflation is “still expected to remain too high for too long.”

The Bank of Japan relaxed its Yield Curve Control, allowing 10-year bonds yields to fluctuate beyond a strict 50 basis point limit for the first time since the policy’s implementation in September 2016. Whereas most central banks attempt to speed or slow economies with very short term interest rates, the Yield Curve Control policy imposed more direct control on economically-important longer rates. Meanwhile, the BoJ left its key short-term interest rate unchanged at -0.1% and 10-year bonds yield target in the 0% range.

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