How will a changing Fed make up its mind?

President Harry Truman famously asked where he could find a one-handed economist. Recent developments in the US economy show why he might have wanted that.

On the one hand, inflation just fell, with the headline consumer price index in June coming in below expectations at a 3.5% annual rate. In principle, this makes rate hikes less likely and, if sustained in future months, could even open the door for a resumption of rate cuts at some point.

On the other hand, the Iran war has started to heat up again, and with it the price of oil. The US economy also continues to show resilience. Gross domestic product (GDP) grew at an annual rate of 2.1% in the first quarter. AI-related spending remains strong, and corporate balance sheets are healthy. Furthermore, the job market has held up well. Three-month average job creation is about 111,000 per month, which is above most estimates of breakeven job growth. The unemployment rate is just 4.2%, still near historical lows. So much for talk of a “no hire, no fire” economy. Sounds great, but if economic growth and slower immigration mean companies have a harder time finding workers, that could put pressure on wages and keep inflation higher. So far, that has not really become a problem, but it's something we're paying attention to. Taken together, these factors weaken the case for rate cuts.

The good news is that oil has come down from its April peak, and tariff-related impacts should fade over time. Because of that, inflation is expected to move lower in the second half of the year. However, oil is going up again, at least for now, and the economy is strong, so it's difficult to see inflation getting back to the Fed's 2% target anytime soon.

All of which creates a tricky situation for the central bank.

If inflation continues to move lower, even if it stays above 2%, the Fed may have enough cover to keep rates on hold this year.

On the other hand, if inflation remains above target and the economy stays strong, you could argue that Fed policy isn't restrictive enough and there are reasons to consider additional rate hikes.

The other issue is that investors don't really know how the Fed will react. The new Fed Chair, Kevin Warsh, doesn’t want to provide too much forward guidance, and he seems a bit more hawkish than many expected. He has also created five task forces focused on Fed communications, the balance sheet, inflation, productivity, and economic data, and we don't yet know what changes may come out of those efforts.

So overall, the economy is doing OK. The job market remains stable. Inflation is moving in the right direction, but it's unlikely to get back to 2% anytime soon. At the same time, the Fed's reaction function has become less predictable. To me, this implies that term premiums will remain elevated and market volatility is likely to stay high for some time.