Prices Stable in May: Time to Cut Rates?

Prices held steady in May, the Bureau of Labor Statistics reported on June 12. The Consumer Price Index grew at a continuously compounding annual rate of just 0.1 percent last month. It has grown 3.2 percent over the last year. Core CPI, which excludes volatile food and energy prices, grew at a continuously compounding annual rate of 2.0 percent in May and 3.4 percent over the last year.

Shelter prices continue to grow faster than almost all other prices. They rose at an annualized rate of 4.8 percent last month and 5.3 percent over the last year. Shelter accounts for roughly a third of the overall price index, meaning shelter price changes have major effects on household purchasing power. Ongoing inflation continues to exhibit relative-price dynamics due to supply-and-demand factors in specific markets.

We should be careful not to read too much into one data point. Inflation appeared to be in check during the second half of 2023. But then it picked up during the first quarter of 2024. Still, the April data marked a modest improvement over March and the most recent data for May are even better. If prices continue to grow around 2.0 percent, as core CPI did last month, the Fed could decide to cut its federal funds rate target sooner than anticipated.

The fed funds target rate range is currently 5.25 – 5.50 percent. That’s a nominal rate: it reflects both the real (inflation-adjusted) cost of short-term capital and expected inflation. Let’s suppose the future inflation rate is the annualized average over the past three months. Expected inflation would thus be 2.8 percent and the implied range for the real fed funds rate target is 2.45 to 2.70 percent.

As always, we must compare the real target range to the natural rate of interest. There is some interest rate that brings capital supply and demand into balance, resulting in full employment and non-accelerating inflation. We can’t observe the natural rate directly, but we can estimate it. Ideally, the Fed’s policy rate will equal the natural rate.

The New York Fed estimates the natural rate to be somewhere between 0.73 and 1.18 percent as of 2023:Q4. Obviously, economic fundamentals have changed since then. Yet it’s still noteworthy that market rates are somewhere between two to three times the natural rate! Judging by interest rates, it looks like monetary policy is quite restrictive.

Monetary data also suggest money is tight, though likely not as tight as the interest rate data indicate. Neutral policy ensures the money supply grows to meet money demand. M2, the most commonly cited measure of the money supply, is up 0.53 percent from a year ago. Since real income and population are growing faster than this, current M2 growth also suggests money is tight. But this is speculative.

In addition to the simple aggregates, we should look at money-supply data that weight components based on liquidity, or how “money-like” the components are. These are growing between 1.01 and 2.06 percent per year. This suggests monetary policy is closer to neutral than the simple-sum M2 aggregate implies. 

At yesterday’s meeting, the FOMC voted to hold its federal funds target range at 5.25 to 5.5 percent. Provided the trend in this month’s Personal Consumption Expenditures Price Index (PCEPI) matches that of the CPI, central bankers should start preparing for rate cuts. We’ve spent the last few years suffering from the consequences of loose money during and after the pandemic. But making money tight would also be a mistake. Excessively restrictive policy creates real economic costs in the form of foregone output and employment. Let’s hope monetary policymakers can strike the right balance.