Fed policy path: Follow the inflation track

Quick takes on capital markets

July 28, 2023 | 2 min read

The Federal Reserve’s decision to raise policy rates by 25 basis points at their July meeting was no surprise to investors. However, future policy decisions are decidedly less certain and will be heavily influenced by the level of core inflation moving forward.

Annual core CPI level at various month-over-month growth scenarios
Februrary 2021–December 2024

Chart showing annual core CPI level at various month-over-month growth scenarios from February 2021-December 2024

Source: Bloomberg, Principal Asset Management. Data as of July 28, 2023.

The Federal Reserve (Fed) raised policy rates by 25bps to 5.25%-5.50% this week, its highest level in 22 years. Notably, financial markets assign an almost 50/50 chance of a further rate hike in the coming months. With rates firmly in restrictive territory, the future policy path sits finely balanced and heavily dependent on how core inflation, currently sitting at 4.8% year-on-year, behaves going forward.

To illustrate the relationship between core inflation and potential policy actions, examine how annual core inflation is affected by different assumptions of monthly inflation.

0.1%: The Fed will likely only cut policy rates this year if the monthly rate falls to 0.1% or below.
0.2%: The Fed would likely keep rates on hold if the June monthly inflation rate of 0.2% is maintained.
0.3%: The Fed may raise policy rates again if core inflation grows at a monthly rate of 0.3%.
0.4%: The Fed would likely raise policy rates several times if the monthly rate reverts to 0.4%, in line with the average monthly inflation rate of the first five months of 2023.

Our long-standing belief has been that interest rates will peak at their current level of 5.25-5.50%. However, the strong economy and tight labor market may still require the Federal Reserve to take further action, considering its close monitoring of inflation's impact on the economy.

Macro views
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