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As we have said before, the U.S. Federal Reserve has a tremendous responsibility to stabilize the value of the U.S. dollar by sticking to its target 2% rate for U.S. inflation.
The U.S. inflation rate began rising well above the 2% benchmark in the spring of 2021 and continued to rise to a peak of 9% in the summer of 2022. Since then, hikes in interest rates have significantly decreased the inflation rate. Nevertheless, the inflation rate has stubbornly remained above 3% since the summer of 2023. The June 2024 measure was at 3%.
However, the Fed has been under pressure since at least the end of last year to decrease interest rates. On July 31, the Fed announced it would hold rates steady at 5.25%-5.50%, hinting a rate cut was possible in September if inflation indicators continued to decline. Two days later, a weak jobs report provided data likely to support a rate cut. Analysts had expected 185,000 new jobs in July, but the Labor Department reported only 114,000. The unemployment rate rose to 4.3%. The Dow shed 600 points on Aug. 2 and 1,000 on Monday. A weaker economy with less job growth portends lower inflation rates, making the case for a rate cut in September or sooner.
Our favorite indicator of future inflation is the St. Louis Federal Reserve’s five-year break-even inflation rate. In its own words, it “represents a measure of expected inflation derived from 5-Year Treasury Constant Maturity Securities and 5-Year Treasury Inflation-Indexed Constant Maturity Securities. The latest value implies what market participants expect inflation to be in the next 5 years, on average.”
When we last discussed inflation on March 15, the five-year break-even inflation rate was 2.39%. Since then, it has trended down and stood at 2.13% on July 31, when the Fed announced it was maintaining rates. Over the next two days, when the weak employment report was released, it dropped to 1.89% but rose to 1.91% the next trading day. The five-year break-even inflation rate has not been below 2% since January 2021.
So, should the Fed cut rates? In our opinion, yes, but incrementally, in September. There is no reason to panic—corrections in the values of equities are a normal part of an economy, and a 71,000 deficit in expected jobs does not mean that much in an economy with a labor force of 168 million. Slow and steady wins the race.•
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Bohanon and Horowitz are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.
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