“The current macroeconomic context is challenging for the Fed”

Eduardo García, Senior Economist at MAPFRE Economics

In line with market expectations, the United States Federal Reserve (Fed) has decided for the seventh time in a row to keep its benchmark interest rate unchanged, at a target range of 5.25%-5.50%. In terms of its perspectives on future monetary policy, it also released a dot plot that suggests a single rate cut of 25 basis points (bps) during 2024, in contrast with the three cuts previously predicted. For 2025 and 2026, the median projections indicate additional cuts of 100 bps each year, while for the longer run, the equilibrium or neutral rate of interest has been increased by 0.1 percentage point (pp) to reach 2.8%.

For the balance sheet, no changes were announced regarding the decreasing trajectory already proposed, which at this point has led to a figure $1.7 trillion lower. Meanwhile, the macroeconomic picture has remained essentially unchanged. Predictions for the GDP growth rate have remained at 2.1% for this year, and at 2.0% for 2025-2026. With regard to inflation, there has been a slight upward revision (by 0.2 pp to arrive at 2.6% for 2024, and by 0.1 pp to reach 2.3% for 2025), although the Fed is still expecting that the inflation target will be achieved in 2026. The statement released by the Federal Reserve can be interpreted as hawkish, coming out in tandem with a new table of economic projections that support a dampening of expectations regarding interest rate cuts. However, during his remarks, the chairman of the Fed’s Board of Governors, Jerome Powell, was clearly making an effort to soften the tone of the message being sent, with backing from an unexpectedly lower inflation figure released just hours earlier. He even suggested a more moderate view regarding the reliability of the latest projections (“they are not a plan”, and “assessment of policy will adjust”).

In general terms, the underlying scenario must be seen as presenting a challenge to the cautious stance being taken by the Fed. Slower economic growth, a more uncertain labor market, encouraging inflation data, and the echo of first interest rate cuts already occurring in Europe and Canada have all fueled expectations of a less prudent approach. Nevertheless, those expectations have to conform to a reality where the Fed still sees a need for “more good data”.

On a positive note, the countdown that began at the start of the year seems to be coming into line with the one being expressed by the Fed itself, with falling numbers (from six cuts to two) and increasing convergence between the official line and the market’s reasoning. In terms of economic activity, the second revision of the GDP data is suggesting something of a slowdown, mainly driven by a drop in consumer spending. This factor could be explained by a depletion of the excess household savings that had previously built up. However, the weakness seen in other sources of incoming data (ISM and PMIs) still appears to be insufficient to shake the underlying growth dynamic, which has allowed the American economy to systematically outperform those of other G7 countries.

As for inflation, in spite of the rough patches that have continued to exist during recent months, the data for May seem to be pointing in the right direction again. Specifically, the CPI held flat (0.0% MoM and 3.3% YoY), while the core CPI reading dropped to 3.4% YoY (0.2% MoM). However, when taking a closer look at the details, it can be seen that there were increases in practically all components (with the 0.4% MoM rise in housing costs standing out again), which were largely being offset by the energy figure (-2.0% MoM).

Looking at changes in the labor market, it seems to be progressively moving towards its pre-pandemic equilibrium, although there is still some ground to cover in this regard. Employment offers have returned to target levels, while the drop seen in the pace of hiring can be partly attributed to a decrease in the number of people leaving their jobs. In terms of unemployment, the uptick in the rate to 4.0% does not seem to be increasing the likelihood of recession (as indicated by the Sahm rule, which determines entry into a recession when the average unemployment rate for the preceding 3 months exceeds the minimum from the last 12 months by 0.5 pp). Instead, it seems to be indicating a return to normality, in line with the Beveridge curve.

In view of all of these figures, the Federal Reserve is still waiting for a more unequivocal body of evidence, before it feels comfortable making a decision to confirm its first interest rate cut. On the positive side, a more balanced macroeconomic outlook is beginning to clear the way for this. Economic activity and employment rates are taking on a healthier configuration, while the latest inflation figures are supporting a more optimistic view. On the downside, however, the base effect is once again becoming a factor for inflation in the coming months, while the positive effect of energy prices is becoming less clear. In addition, changing salary levels are continuing to justify some price rigidity, which seems to reflect a labor market with some room for adjustment before finding its point of equilibrium. In addition to the above, there is evidence that financial stability may be at risk. In view of the first-quarter data published by the Federal Deposit Insurance Corporation (FDIC), and the unfavorable evolution of some credit metrics (such as delinquency rates in certain segments), it seems possible that more regional US banks may become insolvent.

This is a factor that could help tip the scale towards preventive interest rate cuts, suggesting a high likelihood of a rate cut prior to the US elections in November. It can therefore be anticipated that during the second half of this year, the Fed’s monetary policy will be coming into line with the policies of central banks in other developed economies (which have already entered into a cycle of monetary relaxation), and also into line with market expectations, which at the start of the year may have been rather distant from the official path being proposed, but which now seem increasingly justified.