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Date: June 18, 2019
Category: Credit

The Fed’s Fair Warning: Don’t Cut Rates to Boost Inflation

Take a step back to appreciate this economy. It was once unthinkable to see 3.6 percent unemployment without slowing job creation or surging inflation. And yet, here we sit with companies still expanding and inflation still floundering. It’s a modern-day marvel.

Three years ago, the Federal Reserve projected a 4.8 percent unemployment rate with two percent inflation. If that held true, nearly two million less Americans would be collecting paychecks today. Instead, more people are working and wages are higher. So, what’s the problem? Inflation is trying to rain on the parade. It’s low when all other metrics suggest it shouldn’t be. Concern already prompted a pause of interest rate hikes, now some wonder if rate cuts are next. Here are three reasons why that might be a bad idea.

Inflation may not be so low

Yes, core PCE (personal consumption expenditures) fell to 1.6 percent year-over-year in March, but as Fed chairman Jerome Powell noted in his April press conference, the slowdown is transitory. Roughly 50 percent of the decline since July 2018 can be attributed to financial services.1 As the stock market rebounds from its late-2018 decline, expect to see the financial services component of PCE move higher, in turn pushing the core number higher as well.

Core CPI (consumer price index), on the other hand, is moving higher. In March, it jumped 2.4 percent year-over-year on rising gasoline and rent prices. This highlights a key difference between the two measures. PCE measures what businesses are selling, with only 16 percent weighted to housing, while CPI measures what consumers are buying, including roughly 32 percent weighted to shelter.2 This partly explains why the two metrics diverged drastically in March – ending with the greatest disparity since September 2016.

Finally, Powell recently cited the Dallas Fed’s trimmed mean year-over-year PCE figure when expressing his comfort with the current level of inflation. That number sits just below the Fed’s two-percent benchmark. This again indicates that your opinion of inflation is in part dependent on the index you utilize. For some, it’s tenuously low, for others it’s modestly rising, and most importantly, for Powell and the Fed, it appears fine … for now.

Don’t build the next bubble

Over the last 23 years, core PCE has moved above that two-percent annual target most often from 2004-to-2008 – the last years of excess that brought us the Great Recession.3 The central bank relied on Dollar-Store-cheap mortgages that pushed housing and rental prices higher, eventually bumping up broad-based inflation.

Now, the Trump administration is calling for lower rates and lower borrowing costs – i.e. looser monetary policy – in an effort to grow an-already growing economy with stronger hiring and higher wages. The Q1 GDP of 3.2 percent was its highest first-quarter number since 2015, the economy blew past projections by adding 263,000 jobs in April (though exuberance was muted by May’s jobs report), and private sector wages recently grew 3.0 percent year-over-year. That’s not an environment that calls for rock-bottom rates; the aftermath of the Great Financial Crisis was.

A sharing economy’s impact

The Fed correlates a two-percent inflation rate with price stability, officially adopting that explicit target back in January 2012. It’s possible, however, that the number is dated by not taking into account globalization and vast demographic and technological shifts that have altered the way our economy runs.

Most assume that a “tight labor market” will automatically push wages higher and drive PCE to its benchmark. However, what if today’s workers are just working smarter and sharing more? People across the country are making extra money through ride-sharing apps like Uber and Lyft, and by opening their homes to vacationers and business travelers through platforms like Airbnb and VRBO.

This is having a big impact on the economy’s supply side. Instead of running out of workers, or hotel rooms, or transportation options, the economy continues to run strong on less thanks to shared resources.

We believe that’s one reason that inflation remains so low, and a big reason why artificially pushing it higher through rate cuts is a bad idea. It likely won’t have its desired effect on inflation or the economy.

A wait-and-see approach to managing inflation

Instead of reacting to Twitter directives, the Fed seems to be taking the prudent path: wait and see. They will monitor inflation over the next several months, remaining cognizant that the current 10-year Treasury sits at a precarious low if the committee wants to utilize rate cuts in the next downturn, when they could be a potentially useful stimulus to shorten a recession and push growth from lows, not a dangerous mechanism to squeeze the last drop from an-already modern-day marvel.

1 Deutsche Bank Research. 5/19.

2 LinkedIn. Why Does the Fed Focus on a Flawed PCE? 10/3/16.

3MarketWatch. Fed’s pursit of 2% inflation goal may spark next ‘credit bubble,” says RBC economist. 5/1/19.

Resource Securities LLC, Member FINRA/SIPC.

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