03 OCTOBER 2024
Why is the Federal Reserve cutting interest rates when headline CPI is still above its 2% target?
The answer lies in the chart below.
It shows the current Fed funds rate (blue line) against US core CPI inflation (red line). The latter strips out volatile food and energy prices from the headline measure, which supposedly provides policymakers with a more stable measure of underlying inflationary pressures.
For over 20 years it’s been rare for the cost of borrowing to exceed core CPI.
In fact, until recently, it’s only happened twice before and both episodes were marked by extreme economic and market weakness. Firstly, in the mid-2000s, which culminated in the Great Financial Crisis. Then again in late 2018 when rising rates triggered a big US stock market sell-off.
So with the Fed funds rate currently residing at 5% and core CPI a little over 3%y/y, policymakers will be well aware that financial conditions are extremely tight for the more indebted companies and households.
Which is why we should expect this gap to close further over the coming months. Likely via a combination of falling interest rates and a rebound in core CPI.
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