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Everyday Economics: With rate cut, consumer confidence should improve

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Last week, the Federal Reserve delivered its first rate cut since the onset of the COVID-19 pandemic. Historically, reductions in the fed funds rate have occurred in response to slowing economic activity, falling inflation, or external shocks like the dot-com bubble burst, the global financial crisis, or the pandemic. This time is different. After succeeding at bringing inflation down and restoring balance in the labor market, the Fed is acting to preserve a ‘soft landing’.

While headline inflation has eased, partly due to improvements in supply chain issues, core inflation has also moved lower along with cooling aggregate demand. In August, core prices, as measured by the personal consumption expenditures (PCE) index, increased by 0.16%, essentially unchanged from July’s rise. Although core inflation remains 2.6% higher than a year ago – still above the Fed’s target – it is moving in the right direction, maybe even faster than anticipated. Over the past three months, core inflation increased at an annualized rate of just 1.7%, compared to a 2.5% rate over the previous six months.

Wage growth has also moderated and is now only slightly above what would be consistent with the Fed’s 2% inflation target. However, wage disinflation could stall. A slowdown in immigration and thus working-age population growth could constrain labor supply, pushing nominal wages higher. In August, wage growth rose 0.4%, up from 0.2% in July. Wages are still 3.8% higher than a year ago, compared to 3.6% in the previous month. On a three-month seasonally adjusted annual rate, wage growth was 3.8%, slightly higher than the six-month rate of 3.7%.

Why does this matter?

Without a sustained increase in productivity growth (supply), persistently higher nominal wage growth (demand) will continue to exert upward pressure on core prices. The good news is that economic growth has been surprising on the upside, primarily due to rising productivity. The Federal Reserve Bank of Atlanta’s GDPNow estimate for real GDP growth (seasonally adjusted annual rate) in the third quarter of 2024 increased to 2.9% on September 18, up from 2.5% on September 9 and 2.1% the week before.

In a recent interview, Federal Reserve Board Governor Christopher Waller suggested that inflation may be running lower than previously thought. This week’s release of August personal income and spending data, along with the latest core PCE figures, is expected to show further declines in inflation.

However, as inflation cools and households’ purchasing power improves, consumer confidence should improve and demand should move higher. Data on new home sales, due mid-week, should indicate a slight uptick. The latest report from the National Association of Home Builders showed improved builder confidence, with fewer builders offering price cuts or incentives – signs that housing demand may be improving. The good news is that supply is rising along with surges in demand. The latest U.S. Census Bureau new construction data showed a large uptick in housing starts last month.

Maintaining the balance for the U.S. economy – not overheating but also not slowing too much to cause recession risk to increase – will require the Fed to reach a neutral policy stance quickly. As the Fed Chair noted, we will recognize the neutral rate by “its works.” The Fed plans to ease gradually and monitor the economy’s response. But getting to neutral may not be consistent with current market expectations for the path of the Fed funds rate.