In the next couple weeks, unfortunately, the Federal Reserve may have a negative impact on the economy once again. Their actions could potentially exacerbate the current financial situation, but it's their strategy to tackle inflation.

To give you a clear picture, this Wednesday, we're expecting the release of the Consumer Price Index (CPI) inflation data for June. Furthermore, on July 26th, the Federal Open Market Committee (FOMC) meeting of the Federal Reserve will take place, where decisions about interest rate adjustments will be made.

I want to give you a comprehensive overview of the current economic climate, involving inflation, interest rates, and the overall economy. Let's start with a quick historical context. From 2020 to 2022, the Federal Reserve embarked on a massive money printing spree, injecting trillions of dollars into the economy, which resulted in surging inflation rates.

Currently, the Federal Reserve's goal is to manage this inflation and aim for a target of 2%. The method they've chosen is by increasing interest rates. Higher interest rates typically slow down the economy and, consequently, it can also slow the rate of price decreases for goods and services..

To make it clearer, let's use the residential real estate market as an example. If the interest rates rise, so does the mortgage interest rates, making it harder for potential homeowners to afford a house. Less demand then slows down the rate at which house prices increase. This same principle applies to auto loans, small business loans, and even loans for large corporations.

Rising interest rates can put a brake on the economy, affecting all sectors ranging from residential and commercial real estate to banking, auto loans, and even credit card interest rates. Now, a critical question arises: when will the Federal Reserve decide to decrease the interest rates?

In my opinion, the Federal Reserve will consider reducing interest rates when either of two things occur - first, when inflation decreases to acceptable levels, or second, when a significant economic disruption happens.

Let's talk about the inflation route. The Federal Reserve is resolute about bringing down inflation to the 2% target. But what do we mean by inflation here? Is it the CPI inflation, PCE inflation, headline, or core? The Federal Reserve's preferred inflation metric is the PCE core inflation, which currently stands at 4.6%.

Let's have a look at a 25-year graph of the PCE core inflation. As you can see, we're significantly above the 2% target. In the last five years, the PCE core inflation rate hasn't really made much progress. It seems to be stuck around the 4% mark, prompting the Federal Reserve to consider raising interest rates.

The head of the Federal Reserve, Jerome Powell, has recently expressed concerns about wage inflation fueling the overall inflation during his latest visit to Europe. This is why labor market data and job reports are so crucial to the Federal Reserve.

The June job report shows that the US economy added 209,000 jobs, indicating a tight labor market. According to Powell, what we need is a better alignment of supply and demand in the labor market and softer labor market conditions, essentially implying higher unemployment rates.

Powell has also hinted at raising interest rates at least twice more this year. So, after the FOMC meeting concludes on July 26th, if they increase the interest rates by 0.25%, it will push the Fed funds rate to 5.5%.

Despite the likelihood of the CPI headline inflation reported in the 3% range, the Federal Reserve will probably still raise the interest rates on July 26th. The question is, will two more interest rate hikes be enough to slow down inflation?

Many believe that the current robust GDP growth may require even higher interest rates to dampen. Over the last few quarters, we've seen GDP growth rates of 2.6%, 2.0%, and expectations are that the Q2 of this year will result in growth around 1-2%.

But let's consider a few things. Firstly, the positive GDP growth so far has been driven by US consumers. However, if the labor market weakens and unemployment increases, will US consumers continue to support the economy?

Secondly, within three months, over 40 million Americans with student loans will have to start making payments again, diverting money from the economy towards debt servicing. This could impact retail sales as consumers will have less money for discretionary spending. Considering that retail sales make up about 40% of US personal consumption, this could be significant.

In conclusion, it remains to be seen what will happen first - will inflation hit the 2% target, prompting the Fed to cut rates, or will the economy suffer enough damage to force the Fed to pivot?

Until Next Time!