Fed's Challenge: Balancing Dual Mandate Amid Inflation Turbulence

Following a rare public disagreement at the Federal Reserve's September meeting, the November meeting is unlikely to be a smooth one either, as conflicting signals of inflation exceeding expectations and employment data weaker than anticipated have once again put the Federal Reserve in a difficult position.

On October 10th, Eastern Time, data released by the U.S. Department of Labor showed that the U.S. CPI year-over-year growth rate for September decreased from 2.5% in August to 2.4%, marking a six-month decline and reaching the lowest level since March 2021, with a month-over-month increase of 0.2%, slightly above expectations; the core CPI in September grew by 3.3% year-over-year, a new high since June, with a month-over-month increase of 0.3%, also slightly exceeding expectations.

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At the same time, the number of unemployment benefit claims has risen significantly. As of the week ending October 5th, the number of initial unemployment claims rose to 258,000, a level not seen since August 2023, significantly higher than the previous week's 225,000 and the market expectation of 230,000. Additionally, as of the week ending September 28th, the number of continued unemployment claims rose to 1.861 million, higher than the market expectation of 1.83 million and the previous week's 1.819 million, indicating a rising risk in the labor market.

Compared to the higher-than-expected inflation data, the significant increase in initial unemployment claims has received greater attention, leading the market to increase its bets on a 25 basis point rate cut by the Federal Reserve next month.

However, the recent rare public disagreement among Federal Reserve officials indicates that there is no consensus on the current economic data. To achieve the "dual mandate" of fighting inflation and stabilizing employment, there is still a tough battle ahead.

The "last mile" of fighting inflation is fraught with difficulties

As the Federal Reserve enters a rate-cutting cycle, the September inflation data exceeding expectations highlights the challenges of the "last mile" in fighting inflation, which should not be taken lightly at present.

Lu Zhe, Chief Economist of Founder Securities and Deputy Director of the Research Institute, analyzed to 21st Century Economic Report reporters that the overall and core CPI in the United States for September were higher than expected on a month-over-month and year-over-year basis. From a breakdown, food price increases drove overall inflation, possibly related to hurricanes, while core inflation faced a "rise and fall" of increases in various components, with super core inflation (non-residential core service inflation) rebounding for three consecutive months.

The difficulty in the "last mile" of fighting inflation lies in the "stickiness" of core inflation, with several factors keeping the overall core inflation stickiness high.The first is the uncertainty of residential inflation. As a component that accounts for as much as 36.4% of the CPI, several significant and unexpected fluctuations in the month-on-month growth rate of residential inflation this year have caused considerable disturbances in the market. In August, the month-on-month growth rate of residential inflation rebounded unexpectedly, and the year-on-year growth rate also rebounded, while in September, the month-on-month rate of residential inflation fell back, but its sustainability is questionable. The second is the high volatility or catch-up items such as hotel accommodation, air tickets, and car insurance, which are highly volatile and difficult to predict, and have shown a "rise and fall" pattern of increases in recent months, keeping core inflation sticky. The third is that the labor market remains strong, with wage growth remaining high, making wage inflation not significantly improved. In addition, the Federal Reserve has significantly lowered interest rates by 50 basis points, which can easily lead to a rebound in demand and exacerbate the risk of secondary inflation.

Yang Chang, the chief analyst of the policy team at Zhongtai Securities Research Institute, told reporters from 21st Century Economic Report that looking forward, the short-term month-on-month growth rate of the U.S. CPI may still be resilient. Considering that the CPI base started to weaken in October last year, it is important to note the possibility of a rebound in the year-on-year growth rate in the future.

From the perspective of inflation drivers: First, under the disturbance of geopolitical conflicts, crude oil prices stabilized and rebounded in October, and with the base of energy prices last year declining, the year-on-year decline in energy CPI will narrow in the short term; second, the U.S. September ISM non-manufacturing PMI recorded 54.9 (previous 51.5), the new orders PMI for non-manufacturing was 59.4 (previous 53.0), and the business activity PMI recorded 59.9 (previous 53.3), indicating strong demand in the service industry. Coupled with the rebound in U.S. non-farm wage growth in September, it will support core service inflation.

From the perspective of inflation drag factors: First, leading indicators still point to a downward trend in rent price growth; second, the September ISM manufacturing PMI continued to be in the contraction range, with the price PMI at 48.3 and the new orders PMI at 46.1, indicating weak manufacturing economic activity, cooling demand, and that commodity inflation may not have much room for a significant rebound.

Employment data takes the "C position"

Although inflation data supports the Federal Reserve to be more "hawkish," the influence of employment data is even greater, supporting the Federal Reserve to continue to lower interest rates.

Lu Zhe analyzed that the simultaneous release of CPI, which was lower than the previous value but higher than expected, and the initial jobless claims, which were higher than expected, once plunged the market trading into chaos, with both gold and U.S. Treasury bond rates rising. Traders' probability of the Federal Reserve lowering interest rates in November first fell to 75%, then once rose to 96%, and finally stabilized near 91%. The market currently expects the Federal Reserve to lower interest rates by 1.84 times/46 basis points for the rest of the year, and by 5.8 times/145 basis points by the end of next year.

On the one hand, the overall inflation in September exceeded expectations but continued the downward trend, and the inflation risk has been greatly alleviated. During the period of declining inflation, the market's concern about inflation that exceeds expectations is relatively limited. On the other hand, the Federal Reserve's attention to the dual risks of inflation and employment has clearly shifted towards the downward risk of employment, so employment data such as non-farm and initial jobless claims have a greater impact on the market. Of course, the initial jobless claims data for this week were greatly affected by hurricanes, strikes, and other factors, and there is a certain amount of noise.

The focus of the Federal Reserve's monetary policy has temporarily shifted from fighting inflation to stabilizing employment. Yang Chang said that under the current background of preventive interest rate cuts, the Federal Reserve's attention to labor market data has increased. Coupled with the market's tendency to overestimate the level of U.S. employment during hurricanes, the market's expectation for the Federal Reserve to further lower interest rates in November increased after the release of the initial jobless claims data on October 10th. However, the pace of interest rate cuts is likely to slow down from 50 basis points to 25 basis points.Yang Chang analyzed that the Federal Reserve's September interest rate meeting statement proposed "seeking to achieve maximum employment and a 2% inflation rate in the long term," adding the phrase "maximum employment." In fact, before the September interest rate meeting, except for the non-farm data, data such as CPI, PPI, and retail sales did not support the decision to cut interest rates by 50 basis points. The Federal Reserve's eventual 50 basis point rate cut reflected a focus on the condition of the job market.

The Federal Reserve's interest rate reduction policy can be divided into two types according to its intent: preemptive rate cuts and relief rate cuts. The former occurs when the economy shows signs of slowing down but has not entered a recession, while the latter occurs when the economy has already shown signs of recession and relief measures are taken. At the current stage, the US economy has not shown signs of recession, and the Federal Reserve's overall decision-making still belongs to preemptive rate cuts. The Federal Reserve believes that progress has been made in achieving the inflation target, and the economy's position in the dual mandate has risen. Starting the rate cut cycle with a "big step" of 50 basis points also reflects the Federal Reserve's determination to use preemptive policies to hedge against the risk of economic downturn.

How to balance the "dual mandate"?

It is not easy to grasp the delicate balance between stable employment and anti-inflation. How the Federal Reserve balances the "dual mandate" has become a problem that must be faced.

Lu Zhe analyzed that in the September FOCM meeting statement, the Federal Reserve judged that the dual risks of current employment and inflation have become balanced. Therefore, the focus of policy objectives shifted from previously focusing on a single upward risk of inflation to paying attention to both employment and inflation. Under the current thinking of the Federal Reserve, since the confidence in inflation approaching the 2% target has further increased, there is a "head start" in cutting interest rates by a large amount to achieve a soft landing.

Yang Chang told reporters that the Federal Reserve has repeatedly emphasized that achieving maximum employment and price stability is its "dual mandate" and will gradually adjust interest rates to a neutral level that can complete the "dual mandate." Currently, the CME Group's Federal Reserve Watch tool shows that, under the benchmark scenario, the Federal Reserve will cut interest rates by 25 basis points twice in November and December, and will cut interest rates by 25 basis points four times next year, bringing the interest rate to a level of 3.25% to 3.5%.

Regrettably, Federal Reserve officials are also not very clear about what the "neutral interest rate" is. In the September dot plot, most committee members' predictions for the "neutral interest rate" are distributed in a very wide range of 2.4% to 3.8%.

In the special environment after the epidemic, forecasting models have "malfunctioned" one after another. Now, the Federal Reserve can only rely on economic data to "feel the stones to cross the river." Lu Zhe analyzed that the subsequent policy rhythm depends on the data. After the unexpected September non-farm and CPI data, the market's expectation for the interest rate cut in November quickly回调ed from the previous 50 basis points to 25 basis points. Under the benchmark scenario, it is expected that there will be a 25 basis point interest rate cut in November and December, and the rhythm of interest rate cuts next year will largely depend on the election results. Under Trump's policy scenario, his more radical measures such as internal tax cuts, external expulsion of immigrants, and increased tariffs may exacerbate the tail risk of secondary inflation, affecting the Federal Reserve's interest rate cut space next year. Under Harris's policy scenario, the Federal Reserve's interest rate cut space next year is larger, and there may be another 3 to 5 interest rate cuts.

In order to balance the "dual mandate," the Federal Reserve will adjust its policy at any time in the future. Yang Chang analyzed to reporters that future uncertainties such as the Middle East geopolitical situation and election results will affect changes in US employment and prices. The deterioration of the Middle East situation will raise commodity prices and increase the risk of inflation. The different election results of the US presidential election and the US Congress will bring differentiated impacts. In this case, the market's expectations for monetary policy may still undergo multiple adjustments. However, it is precisely because the Federal Reserve has a larger monetary policy space and the flexibility to adjust policy according to data that the probability of a soft landing for the overall US economy remains high.