Memo to Fed: lower interest rates are overdue

The inflation news continues to get better. Indeed, inflation has beaten official expectations for the past two years—yet the Fed remains cautious. Fed-watchers are familiar with this: the Fed is always slow to catch on to the prevailing fundamentals. They waited too long to tighten (as they did throughout 2021, despite abundant evidence that M2 had exploded and measured inflation had surged), and then they waited too long to ease (not cutting rates until in late 2024, almost 18 months after inflation had fallen from 9% to 3%). 

In the past (before the Fed adopted an abundant reserves policy), such mistakes had severe consequences: once policy became tight enough to slow the inflation fueled by a delayed response to higher inflation, the economy invariably suffered a recession. Today it looks like we will avoid a recession, but that doesn't ensure we won't see some housing market turmoil. Liquidity in the housing market is terribly low and prices are unsustainably high, all on top of a surging inventory of homes for sale. And to the chagrin of would-be home buyers, 30-yr mortgage rates are hovering just under 7%—which equates to a crushing real interest rate of about 5% per year. If Fed policy had been more responsive in the past decade to swings in inflation, mortgage rates today would be far lower. 

Meanwhile, in the good news column, today's May inflation report showed that consumer prices on average rose a mere 0.1% in May, and are up only 2.4% in the past year. However, excluding shelter costs (which are now widely understood to be a seriously lagging statistic that effectively overstates current inflation), the CPI is up only 1.5% in the past year. Abstracting from shelter costs, consumer prices have risen at a 1.8% annualized rate for the past two years. In other words, inflation has been below the Fed's target for a full 2 years. Long-time readers will know that I first made this point two years ago.

Memo to Fed Chair Powell: lower interest rates are not only justified but long overdue.

Chart #1

Chart #1 illustrates the relatively large gap between headline inflation and inflation ex-shelter costs. This gap has been narrowing for the past two years (though the narrowing has been slower than I thought it would be). Excluding shelter costs, consumer price inflation has been less than 2.0% year over year in 19 of the past 24 months; on an annualized basis, ex-shelter inflation has been 1.8% over the past two years. 

Chart #2

Chart #2 shows the portion of the CPI that corresponds to shelter costs: Owner's Equivalent Rent makes up about one-third of the CPI. Shelter cost inflation by this measure has been declining for over two years. 

Chart #3

Chart #3 shows how the year over year change in housing prices 18 months ago feeds into the OER component of today's inflation. (I have shifted the red line 18 months to the left to show this.) The most recent evidence of housing prices shows that in most areas of the country, home prices are roughly flat to down. This all but ensures that the OER component of the CPI will subtract meaningfully from consumer price inflation for the next year or two.

P.S. The FOMC meets next Wednesday, so that's the earliest we could see a rate cut. However, the market is betting that there is almost no chance the Fed will lower rates next week. The market is not expecting any cuts until the September 17 FOMC meeting, and only a 20% chance of a cut at the July 30 meeting. That seems like an awfully long time to me.

Jobs growth is moderate but likely to slow

A quick post focusing on today's May '25 jobs report.

Anyone who has followed the monthly jobs numbers for a few years knows that they are volatile and subject to significant revisions from time to time. I've tried to correct for this by stepping back and trying to see the long-term trends and whether they are changing.

As this chart shows, private sector jobs (the ones that really count) have been growing at an annual rate of a bit more than 1% for most of the past 18 months. Over the past decade, private sector jobs have grown at an annualized rate of 1.3%, while real GDP growth has been about 2.3% per year. So what we are seeing today is roughly par for the course; nothing to get excited or worried about. Except that the number of immigrants entering the labor market is in the process of slowing rather dramatically, thanks to Trump's closed borders and aggressive efforts to deport illegals. My back of the envelope calculation says that without any meaningful policy changes, jobs growth is going to slow to somewhat less than 1% a year—possibly to as low as 0.6% a year by the end of this year. This is going to leave us with an economy that struggles to grow 2% a year.

This is not the stuff of booms. For a booming economy we need to see significant reductions in tax and regulatory burdens. Fortunately this is something that Trump is working hard to achieve, so there is hope for a better economy in the years to come. 

Inflation pressures were tamed a few years ago

A quick note on the latest inflation data through April '25.

Chart #1

Chart #1 shows the total and the core (ex-food and energy) measures of the Personal Consumption Deflators. The PCE deflator is a better measure than the CPI, because the weightings of its components are dynamically adjusted to account for changes in consumer behavior. Both measures are within spitting distance of the Fed's target—the PCE deflator rose only 2.1% in the year ending April '25. The big-picture takeaway here is that the surge in inflation which occurred in the wake of the Covid crisis ended in mid-2022. It's all over but the shouting.

Chart #2

Chart #2 shows the three major components of the PCE deflator. Note that durable and non-durable goods prices have been essentially flat for the past 2-3 years. In particular, raw industrial commodity prices are unchanged since October '22, while most commodity indices exhibit similar behavior, with the exception of energy prices, which have fallen significantly since mid-2022. Inflation is an issue only in the service sector, and those prices are dominated by wages and shelter costs, both of which tend to be lagging indicators of inflation pressures on the margin. Meanwhile, we know that housing prices continue to soften, and with only moderate increases in the money supply, it is likely that wage pressures will soften as well.