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%.
Read more of RSM’s insights on inflation, the economy and the middle market.
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.
