Fed Rate Cut Expected Amid Uncertain Inflation Targets

ORLANDO, Florida – The Federal Reserve is widely expected to cut interest rates next week, despite inflation still hovering around 3 percent, which is a full percentage point above its official goal. This situation raises a critical question: is the central bank’s 2 percent inflation target still viable?

Data on Thursday is anticipated to reveal that annual core Consumer Price Index (CPI) inflation remained steady at 3.1 percent in August. The Fed’s preferred measure, the annual core Personal Consumption Expenditures (PCE) inflation, registered at 2.9 percent in July. Easing policy under these conditions would mark an unusual step for the Federal Reserve.

The Fed had already cut rates late last year when core CPI was at a higher rate of approximately 3.3 percent, a decision that faced criticism since unemployment did not rise as officials had predicted and long-dated yields increased. Historically, the last instance of the central bank easing policy while the core PCE inflation stood at 3 percent dates back to the early 1990s, prior to the unofficial adoption of the 2 percent target.

The economic landscape then was dramatically different, with limited internet access and no smartphones. The possibility of the Fed reducing rates again this year with core inflation at 3 percent represents a significant departure from established norms, suggesting that recent economic theories may be under scrutiny.

Inflation hawks express concern, particularly as federal debt and deficits reach record levels during peacetime. These factors fuel concerns that long bond yields could begin to rise again. However, financial markets currently do not appear overly anxious. Gold prices, for instance, have surged nearly 40 percent this year, hitting record highs consistently.

While financial markets have remained stable, they are not completely devoid of concerns regarding the potential loosening of the Fed’s 2 percent inflation target. The 2s/30s yield curve steepened approximately 70 basis points to a four-year high, although the 30-year yield itself has edged down this year. Meanwhile, U.S. corporate bond spreads have reached historic lows, and stock markets continue to reach new heights.

The equity markets typically experience upticks during periods of rising inflation, albeit these increases are often short-lived once consumer inflation expectations shift. At present, research indicates that consumers are not accurately forecasting inflation levels. A New York Fed survey revealed that consumer expectations for one-year inflation increased to 3.2 percent in August, up from 3.1 percent in July. Longer-term forecasts remained steady at 3 percent and 2.9 percent.

Many are speculating that the experience of 3 percent inflation may be leading to a new norm, aligning with President Donald Trump’s perspective of fostering stronger economic performance. Some economic analysts, such as retired strategist Jim Paulsen, have criticized the emphasis on a rigid 2 percent inflation target, arguing that federal officials should rely on their judgment rather than adhere strictly to historical targets. He noted that the headline CPI has averaged 2.9 percent for the last two years.

As we approach a potential 3 percent inflation print this Thursday, followed by a rate cut, questions persist about the Fed’s future commitments to its 2 percent target.