U.S. inflation expectations are well anchored as Fed nears decision

American inflation expectations remain remarkably well anchored given the price shock of the past two and a half years.

Our preferred measure of inflation expectations—the Federal Reserve’s five-year forward, five-year breakeven rate and the five-year forward breakeven index—imply that professional investor expectations are at or near long-run averages, with the former standing at 2.25% and the latter at 2.2%.

On Friday, the Fed will get its first look at the personal consumption expenditures index for May. The central bank uses the year-over-year PCE, which currently stands at 2.7%, as its policy variable on inflation when formulating interest rate decisions.

Our forecast for May implies growth of 0.1% on the month and 2.6% on an annual basis. As inflation continues to cool back toward the 2% trend, it is appropriate that the Fed ease the policy rate to a still-restrictive rate of 4.75% to 5% by the end of the year.

Our read on the economy, hiring and the labor market suggests that the Fed can ease rates without dislodging well-anchored expectations and still establish price stability.

Over the past 20 years, the Fed’s five-year forward, five-year breakeven has averaged 1.94% while the five-year forward breakeven has averaged 2.33%.

Should growth, hiring and inflation continue to cool, the Fed will be well positioned to reduce its federal funds policy rate from its current restrictive 5.25% to 5.5% rate.

The takeaway

Our forecast implies one 25 basis-point cut in September and another in December followed by four 25 basis-point cuts next year, which would bring the federal funds policy rate to a range of 3.75% to 4% by the end of next year. At that point, we expect the annual PCE rate to have reached the 2% target.

This article was written by Joseph Brusuelas and originally appeared on 2024-06-21. Reprinted with permission from RSM US LLP.
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