Jerome Powell: The Great Inflation Stalemate Has Begun

We know that reducing policy restraint too soon could result in a reversal of the progress that we've seen on inflation. At the same time, reducing policy restraint too late or too little could unduly weaken economic activity and employment. Right now, the American economy hangs in the balance.

During the pandemic, there was a lot of stimulus from the Federal Reserve and the government, which ultimately spurred inflation up to a high of 9.1% in June 2022. To rein this inflation back in, the Federal Reserve went on their largest string of interest rate hikes since 1980 to raise the US federal funds rate from 0 to 5.25 to 5.5%. Now, that was effective in lowering inflation back down to around 3%, but the annoying thing is that this 3% range has been fairly sticky.

The Federal Reserve and inflation are in a bit of a stalemate. The Fed is leaving interest rates high, neither raising nor lowering them for the time being, but inflation is staying stubborn above the Federal Reserve's target of 2%. Inflation has eased substantially from a peak of 7% to 2.7%, but it is still too high. We are strongly committed to returning inflation to our 2% goal in support of a strong economy that benefits everyone.

So, long story short, the US economy hangs in the balance, and everyone is currently playing the waiting game. If inflation bucks the trend and falls back down closer to 2%, then interest rates will likely be lowered slightly. But if this 3% stalemate continues, we shouldn't expect to see interest rates change; in fact, they may even go up. For this reason, there have been a lot of eyeballs on the monthly inflation data releases and the almost monthly commentary from Jerome Powell on what the Federal Reserve will do next.

Honestly, there's been a lot more coverage in mainstream media than there really should be for a topic like this. But last week, we did get an update on how inflation is going in the United States. Now, inflation is most commonly assessed by looking at the Consumer Price Index. The Consumer Price Index is simply a big basket of common goods and services that most people need to buy. It includes costs for food, energy, transportation, apparel, medical costs, housing, and so on.

The idea is to track the cost of this basket of goods and services over time so you can watch how the price of that basket changes. If it goes up, you have inflation; if it goes down, you have deflation. Now, leading up to the latest release of data, the CPI annual inflation rate was sitting at 3.4%, above the Fed's target of roughly 2%. Now, if you look at the most recent data, the annual inflation rate came in at 3.3%, which is a slight reduction, but again, it's not the kind of movement that will make the Federal Reserve excited that inflation is falling back down to where it needs to be.

Now, beyond the standard Consumer Price Index, another number that is frequently analyzed by economists is what's known as core CPI, which just removes the food and energy categories. Now, while that probably strikes you as deceptive because they're starting to tinker with the numbers, economists find that across the short term, both food and energy costs can be reasonably volatile, and it tends to skew the inflation data from month to month.

So, to get what they call a better understanding of the true inflation rate, they remove food and energy, but in doing so, at the moment, you actually get a slightly higher annual inflation rate at 3.4%, meaning inflation really is there, and it's not just being inflated by volatile categories. But interestingly, when it comes to inflation, the Federal Reserve actually looks at a different primary metric than the Consumer Price Index. They actually look at a number called personal consumption expenditures, or PCE.

Now, PCE is similar; it's still tracking the cost of a basket of goods or services. However, PCE measures a larger number of items compared to CPI, and CPI only includes expenditures made by a household. So, PCE measures a broader swath of items and also includes purchases made on behalf of the household, such as expenditures for medical care made by employers or the government.

PCE also weights the categories of goods slightly differently, but overall, it is still a very valid measure of inflation, and as I said, it's the one that the Federal Reserve watches more closely. Now, if we turn to that index, the most recent data shows that inflation is around 2.7% across the last 12 months ending in April. And again, economists also do a core PCE number, which excludes food and energy, which came in at 2.8%.

Here's the Federal Reserve Chairman Jerome Powell explaining exactly these statistics in a meeting from just last week: "Inflation has eased notably over the past two years but remains above our longer run goal of 2%. Total PCE prices rose 2.7% over the 12 months ending in April; excluding the volatile food and energy categories, core PCE prices rose 2.8%. The Consumer Price Index, which came out this morning and tends to run higher than the PCE price index, rose 3.3% over the 12 months ending in May, and the core CPI rose 3.4%."

So that's a bit of an explainer as to how the inflation data gets tracked, but the short of it is this: We just got this fresh inflation data, and it keeps reaffirming that unfortunately, inflation isn't dead yet. Yes, it's certainly a lot better than where it was a few years back, but it's annoyingly staying above that 2% level that the Federal Reserve needs to see it come down to, and this is leading the Fed to have to make some tough decisions.

At the start of this year, the FOMC expected, on balance, that they would be able to lower interest rates about three times. But because of this sticky inflation situation, they've had the unpopular task of telling America that actually, this probably isn't going to happen and they need to keep interest rates at their highest level since literally the turn of the century. The committee decided at today's meeting to maintain the target range for the federal funds rate at 5.25 to 5.5% and to continue reducing our securities holdings.

We've stated that we do not expect it will be appropriate to reduce the target range for the federal funds rate until we have gained greater confidence that inflation is moving sustainably toward 2%. So far this year, the data have not given us that greater confidence. The most recent inflation readings have been more favorable than earlier in the year; however, there has been modest further progress toward our inflation objective.

We'll need to see more good data to bolster our confidence that inflation is moving sustainably toward 2%. So, the US economy hangs in the balance. For the next part of the video, I wanted to talk about what you can expect to happen in both scenarios: the scenario that inflation does cool down and also the possibility that the sticky inflation continues to be sticky and even rises further from here.

So, Exhibit A: Inflation comes down. If inflation comes down, then it's a cautious sigh of relief from everyone. Inflation trending back down to 2% will inevitably have the Federal Reserve starting to lower interest rates. I wouldn't expect them to lower them by a lot, maybe 1 to 2%, but this will still boost the economy. It will ease the clamp on mortgage rates, which will likely see an uptick in people buying homes, which should help home prices rise.

And if you have a variable rate home loan, then this will ease your monthly payments. From the stock market perspective, it should also assist stock price appreciation, as lower interest rates make it easier for companies to borrow for growth initiatives. Along with higher spending from the public due to the consumer now having more disposable income, it should culminate in better business performance, which should translate to higher share prices.

On the flip side, however, lowering interest rates also has the potential to reignite inflation, which the Federal Reserve will be watching incredibly closely. So that's Exhibit A. Then Exhibit B: Inflation stays where it is or even rises further. If this happens, well, we could kiss away the idea of interest rate declines. At the very least, interest rates will stay where they are, meaning homeowners will continue to have their disposable income sapped up by high mortgage costs, car loans, and so on.

While nobody really knows these days, typically in these conditions, you can expect property prices to level out, as typically there is more mortgage stress, which leads to more inventory coming to the market. However, we have not exactly seen that eventuate this time around. Median house prices have leveled off, but inventory is still quite low. And then, in a situation where interest rates are quite high or rising, you tend to see the stock market underperform, as the clamps are put on businesses' growth plans, and also consumers tend to have less to spend.

So that's the theory anyway. It did play out in 2022 as interest rates were hiked. However, with the AI hype in the market these days, I don't know; it doesn't look like the S&P is slowing down anytime soon. But it is generally an unfavorable situation having interest rates high for a long time, as it takes money out of people's pockets, slows business performance, and typically brings down asset values.

The one thing that does get juicy, however, are government bonds. As opposed to the time of the pandemic where bondholders were getting absolutely nothing, you can now buy short-term US Treasuries giving you around 5% to 5.5%, which is not too shabby. So there's some reprieve for investors, but generally speaking, if inflation stays high, you shouldn't expect economic conditions to be all that great. And that's the fear at the moment; the longer interest rates have to stay high, the worse it gets.

So that's why the US economy currently hangs in the balance. It could go either way. So, with that said, what does the Federal Reserve think will happen over the next little while? Well, turning to the economic projections released on the 12th of June, we can see that they're expecting GDP, the main measure of economic growth, to stay around 2% in 2024, 2025, and 2026. They also expect the unemployment rate to stay around 4%.

But then we hit the interesting stuff, which is their inflation and interest rate predictions. So, for PCE inflation, the number they keep saying they want to get back down to 2%, the median FOMC member sees that situation not occurring this year, not next year, but sometime around 2026. The median projection in the SEP for total PCE inflation is 2.6% this year, 2.3% next year, and 2.0% in 2026.

And if this were to eventuate, it's likely interest rates would stay reasonably high during that period. And as you can see, the FOMC median interest rate predictions come in at 5.1% for 2024, 4.1% for 2025, and 3.1% for 2026. So current from the FOMC is very much that inflation will take some time to cool off, and thus interest rates will be kept reasonably high over the next few years. There's one thing we can put in the book, though: it's that the ultra-low interest rate environments that dominated the 2010s are definitely behind us, so it's probably best to prepare accordingly.

So that is the current update to the American macroeconomic situation. The only other thing I wanted to mention is that with all of this crystal ball work, please, please remember to take all the predictions and numbers with a grain of salt. The truth is, nobody can predict the macro with certainty, and that's actually evidenced by the Federal Reserve themselves. They are literally the people with their hands on the interest rate lever, and not even they can accurately predict where inflation and interest rates will be over time.

So, as I always say with this stuff, it's good to keep in the know, but don't let it affect your investment decisions. But with that said, guys, thanks very much for watching. Be sure to check out New Money Education if you'd like to learn a full step-by-step guide to investing, either passively or actively; that also supports the stuff that we do here on YouTube. So, a big shout-out to everyone, a big thank you to everyone who has decided to buy a course and support our work.

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