MNI INTERVIEW: Fed May Pause When Core Prices Fall Under 3.5%

The Federal Reserve could pause interest rate increases once trailing 6-month annualized core inflation falls below 3.5%, which could come around March if not earlier, a former senior Fed Board researcher told MNI.

John Roberts, a former deputy associate director at the Fed Board in Washington who oversaw its domestic economic modeling efforts, said looking at two-quarter changes in core PCE prices provides a good balance between timeliness and noise reduction.

In his model simulations, he found that the Fed could pause once six-month core inflation falls below 3.5% and still meet its inflation goals. “But they won’t look only at core PCE inflation,” he explained. “They will also look at alternative measures of core inflation, like the Dallas Fed’s trimmed mean. And they will want to see key measures of wage inflation moving down as well.” The Dallas Fed's trimmed mean 6-month annualized measure was 4.3% in July.

SLOPING UNEMPLOYMENT

The Fed has raised rates aggressively this year to combat high price pressures and at its June and July policy meetings, raising the federal-funds target rate range by 0.75-percentage-point increments, a historically aggressive action. It is next scheduled to meet September 20-21 where it will issue fresh forecasts in its Summary of Economic Projections including for the year 2025.

Noting recent work by Fed staffer Andrew Figura and Fed governor Chris Waller that suggested the unemployment rate may need to rise to 4.5% to return the labor market to better balance, Roberts thought it possible the next SEP could show higher unemployment. “You might see the unemployment path through 2024 a bit more upward sloping than in June," he said. (See: MNI INTERVIEW: Fed Sept SEP Must Reflect Rate Hike Pain - Dudley)

“That may mean tighter policy than in the June projections,” with the funds rate path running higher, “perhaps by 25 basis points or so," said Roberts, a former special adviser to then-Fed Governor Lael Brainard from 2017 to 2019. The June SEP showed the fed funds rate ending the year at 3.4% and 2023 at 3.8%, before moving down to 3.4% in 2024.

Roberts’s model simulations, which were based on the June SEP, suggested that the peak in the funds rate could be reached at the March meeting. But recent statements by policy makers suggest the Fed might move more aggressively than that, so that the peak could be moved forward to December or January, he said.

"Then you might see in the SEP it would be holding relatively flat between the end of 2022 and the end of 2023, or maybe just up another quarter point in 2023," said Roberts, who served at the Fed Board for more than 35 years.

RATE CUTS

Roberts pointed out that the June SEP, which Chair Powell last week suggested was still a good guide to Fed thinking, had the funds rate moving down in 2024. His simulations suggested that those outright cuts likely wouldn’t happen until six-month core inflation was below 2.5%.

“When they put out their 2025 projections in September, inflation will likely be within striking distance of the Fed’s 2% target, and the funds rate will be headed down towards its long-run neutral rate of 2.5%," said Roberts, who once oversaw the staff production of alternative scenarios and model-based monetary policy analysis that were presented to the FOMC as part of their meeting preparations.

With interest rates coming down, it’s possible the SEP will show an outright decline in the unemployment rate, he added.