Introduction to Inflation and CPI
The consumer price index, commonly referred to as CPI, measures changes in the price of consumer goods and services, from food and housing to medical care and transportation. This index is primarily used to determine current inflation and predict how prices might change in the near future. According to the Labor Department’s most recent report, CPI in June was 2.7% higher than one year prior and 0.3% higher than in May.
The Numbers Behind Inflation
Inflation has eased in various parts of the economy. However, Americans continue to face persistent “sticky inflation” in specific sectors, complicating the Federal Reserve’s efforts to manage the situation. Sticky inflation refers to price increases for certain goods and services, such as insurance, public transportation, and rent, that tend to take longer to adjust. Some key indicators of inflation include:
- Food prices increased 0.3% compared to May and 3.0% compared to a year ago.
- Energy prices increased 0.9% compared to a month ago but are down 0.8% since last June.
- Shelter costs were up 0.2% compared to May and 3.8% compared to June 2024.
Why CPI Matters to the Economy
Since early 2022, inflation has been the Federal Reserve’s primary economic challenge. To address this, the Federal Open Market Committee—the Fed’s branch that develops monetary policies—has aggressively changed U.S. policies to bring inflation down. Part of the Fed’s role is managing pricing stability and employment with interest rate adjustments. According to the FOMC, an annual target increase in inflation of 2% is consistent over the long run with a strong economy.
How the Fed Uses CPI Data
CPI data is one of the Fed’s measurements of our economy’s health and whether policy changes are needed. Depending on how the prices of consumer goods and services shift over time, the Fed may decide to raise or cut interest rates. The federal government also considers CPI data when it adjusts benefits like Social Security, federal pensions, and the federal income tax structure.
The Decision to Cut Interest Rates
The FOMC decides if and when to change the federal funds rate, the interest rate banks charge to borrow money from their reserve balances overnight. By setting a target range for this rate, the FOMC can influence borrowing, spending, and investing across the economy. Ultimately, the Fed aims to keep prices stable and employment high. The Fed cuts interest rates to increase economic activity. When interest rates are low, people tend to borrow and spend more. Conversely, the Fed raises the federal funds rate to slow economic activity and reduce inflation.
What an Interest Rate Cut Means for the Economy
When the Fed cuts its federal funds target rate, it signals banks to lower their loan rates, making it cheaper to borrow money. As a result, people and businesses tend to take out more loans and make larger purchases, and the economy grows. An interest rate cut could mean one or a combination of a few things:
- Inflation is in check and prices are expected to remain relatively stable in the near future.
- Unemployment is trending upward or there aren’t enough jobs being created.
- The economy is not as strong as it could be and requires increased activity.
Current Interest Rates and Their Impact
The U.S. federal funds target rate is currently between 4.25% and 4.50%, with the prime rate hovering around 7.5%. The prime rate, or the benchmark by which banks determine their interest rates for multiple loan types, typically reflects the upper end of the federal fund range plus an additional 3%. Although the current federal funds rate marks a drop from the recent peak of 5.25% to 5.50%, rates remain relatively high. The Fed dramatically increased the federal funds rate to reduce post-COVID-19 inflation from March 2022 to June 2023.
The Risk of Recession
A range of factors can lead to an economic recession or an extended period of declining economic activity, and it’s not easy to accurately predict if one is on the horizon. Many economists had forecast a recession in 2024, but this prediction proved false. According to J.P. Morgan research, there is a 40% chance of a recession occurring with the expectation of “material headwinds to keep growth weak through the rest of this year.” This estimate is based on a weakening job market and decreasing momentum in global manufacturing.
What’s Next for the Economy
The Federal Reserve is working to balance high interest rates while gradually reducing inflation without tipping the U.S. economy into a recession. Interest rate cuts have historically benefited growth stocks, as higher rates can hurt discounted cash flow valuation, which is the estimate of an investment’s current value based on future projections. With investors assuming lower interest rates are just around the corner, tech stocks and growth stocks have surged. In 2025, we can expect additional interest rate cuts as the Fed continues to control inflation, with unemployment rates becoming the main focus for the FOMC.
Conclusion
In conclusion, understanding the CPI and its impact on interest rates is crucial for navigating the current economic landscape. As the Fed works to balance inflation and economic growth, consumers and investors must stay informed about the latest developments in monetary policy. By doing so, they can make more informed decisions about their financial futures and adapt to the ever-changing economic environment. The coming year will be critical in determining the trajectory of the economy, and all eyes will be on the Fed as it continues to manage interest rates and guide the economy towards a path of stable growth and low inflation.
