Washington, D.C. – The United States economy experienced a mild bout of deflation in May, as reported by new data from the Bureau of Economic Analysis. The Personal Consumption Expenditures Price Index (PCEPI), used as the Federal Reserve’s gauge of inflation, showed a decrease of -0.1 percent in May 2024, down from 3.2 percent in the previous month. Over the last year, the PCEPI has risen by 2.5 percent, and it has been increasing at a rate of 3.8 percent per year since January 2020, just before the onset of the pandemic. This means that current prices are 8.9 percentage points higher than they would have been if the Fed had met its 2 percent inflation target during this period.

Core inflation, excluding food and energy prices, has also seen a decline. The Core PCEPI experienced a growth rate of 1.0 percent in May 2024, down from 3.1 percent in April and 4.0 percent in March. Similar to the overall PCEPI, the Core PCEPI has increased by 2.5 percent over the past year and by 3.6 percent per year since January 2020.

Recent projections from the Federal Open Market Committee (FOMC) suggest that the federal funds rate target range may need to remain at 5.25 to 5.5 percent for a longer duration than previously anticipated. The median FOMC member projected just one 25-basis point rate cut for the year, down from three projected in March. Eight members predicted two cuts, seven predicted one cut, and four projected no cuts.

The latest inflation figures further support the case for lowering the federal funds rate target. As inflation decreases, the real federal funds rate target increases. To prevent this increase in the real interest rate and further tightening of monetary policy, the FOMC will need to lower its nominal federal funds rate target.

An illustrative numerical example helps clarify this notion. When the FOMC set the current target range in July 2023, inflation was higher than it is now, with the PCEPI and Core PCEPI experiencing lower rates of growth compared to the previous year. This discrepancy highlights the importance of assessing the difference between the real federal funds rate and the natural rate to determine the stance of monetary policy.

In light of declining inflation and estimates of a lower natural interest rate, it appears that the current monetary policy has become tighter. As such, cutting the federal funds rate target would be a step toward returning policy to a neutral position and avoiding potential economic setbacks.