BY: Jim McElroy
Two Percent
The Federal Reserve, as well as the European Central Bank, have famously promoted 2% as the optimal and desired rate of inflation for the economy, one that strikes the perfect balance between stable prices and full employment, the primary goal of the central bank; for that reason it is often called the neutral inflation rate. As the theory goes, an inflation rate well above 2% pushes borrowing costs higher, encourages spending over investing and discourages both innovation and growth, leading to reductions in hiring. An inflation rate much lower than 2% reduces business profits, which leads to hiring freezes and layoffs. Neither path is pleasant — they both lead to higher unemployment — though the path that significantly undershoots a 2% rate runs the risk of falling into a deflationary spiral and possibly a depression, something that central bankers wish at all cost to avoid. The 2% solution has been a mainstay of Federal Reserve deliberations for decades, though it seems to have become much more salient in the aftermath of the pandemic. During the chaos of the pandemic, we witnessed extreme variations in both the unemployment rate and the inflation rate: in April of 2020, the unemployment rate jumped from 3.5% to 14.8% and the annualized monthly rate of change of core PCE inflation — the Fed’s preferred inflation measure — hit a negative 3.9% (deflation). For two years, the Fed kept its funds rate at a 0% level despite multiple months of annualized core PCE inflation well over 2% and at least two annualized readings over 7%. However, by 2022, after two years of arguing that the monthly inflation numbers were tainted by disruptions in supply chains and likely to be transient, the Fed returned to its 2% plan and embarked on a tightening regime that in eleven consecutive FOMC meetings raised short term rates from near zero to over five percent. For almost a year now, the Fed has managed a much tighter range around the neutral rate of 2% inflation. In 2023, there were actually five months (July, August, October, November and December) in which, on an annualized basis, the Fed met its two percent inflation target. However, in the first four months of 2024, this positive trend appears to have faltered or at least become more mixed: core PCE prices were up 1.3% (or 5.4% on an annualized basis) through April but did decelerate to a .08% (.998% annualized) rate for May. It’s clearly too early for the Fed to declare a victory.
The Fed’s job is not an easy one. Besides having to make educated guesses about the neutral rate of inflation (currently guessed as 2%), it also must make educated guesses about the desired level of the Fed Funds rate, which would establish and maintain this neutral rate of inflation. This rate, one which neither stimulates nor restricts economic growth and encompasses the neutral rate of inflation, is known as the neutral interest rate. Like the neutral inflation rate, the neutral interest rate is unobservable. But, of course, this does not free the Fed from having to make estimates of what the neutral rate of interest may be. For years, the Fed believed that the rate was 2.5%, but in March, the Fed opined that the rate was likely 2.6%. Even more recently, it upped its estimate to 2.8% with the suggestion that it could be even higher. The neutral interest rate is mostly a hypothetical number which changes according to circumstances — it could very well be a will-o’-the-wisp — but it does serve as a model for where the Fed today would like to see its overnight rate land, when or if it has brought inflation down to the neutral and sustainable 2% level. Based on this model, a neutral inflation rate of 2% is compatible with a Fed Funds rate (or neutral interest rate) of 2.8%. At the most recent meeting of the Federal Reserve (June 11-12), facing what appears to be a return to a plus 5% annual rate of inflation, the committee exercised patience rather than panic and left the rate unchanged, deeming the 5.25% to 5.5% range that it set back in July of 2023 to be restrictive enough. And in a further demonstration of confidence, the committee “penciled in” up to five rate cuts (presumably of .25% each) in the overnight rate by the end of 2025. Many, if not most, outside observers expect at least one of these rate cuts before the end of 2024. Overall, this would result in a range of 4.00% – 4.25% at some point over the next eighteen months. There’s a substantial difference between 4.00% – 4.25% and the putative neutral interest rate of 2.8%. If the Fed is serious about a 2% neutral rate of inflation — and we have no reason to suspect otherwise — and reported inflation cooperates, then we should expect an eventual Fed Funds rate closer to 2.8% than 4.00% – 4.25%, which the committee is currently suggesting. A lot can happen over the next eighteen months — a recession, price deflation, a booming economy, runaway inflation, etc. — all of which could overthrow the Fed and the market’s calculations. But if the Fed begins to see 2024’s monthly inflation numbers return to 2023 levels, interest rates are likely to fall further and faster than most observers expect.
Much of the action in the markets so far this year has been in equities. The S&P 500 is hitting new historical highs and is up 14 year to date. Much of this enthusiasm for stocks is based on the excitement attached to the “newest new thing”, artificial intelligence, and the outsized impact that it has on the capitalization weighted S&P 500. On a valuation basis, the P/E of the index on forecasted earnings is 22, well above the long-term average of 16. The earnings yield on the index (the inverse of the P/E ratio) at 4.5% is almost indistinguishable from the current 4.25% yield on a ten-year treasury bond. This would normally indicate an inadequate reward, or risk premium, for holding stocks over bonds. However, with the expectation of a Fed-driven decline in interest rates, the equity premium over 10-year Treasuries expands as the yield on bonds declines. And if the Fed is able to engineer a 2% solution in inflation with low unemployment, then the stock market may find itself setting even more new records.
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This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.
