As the country experienced mild deflation in May, it might be time for the Federal Reserve to lower the federal funds rate, according to an economist at Florida Atlantic University.

As the country experienced mild deflation in May, it might be time for the Federal Reserve to lower the federal funds rate, according to an economist at Florida Atlantic University.          

The Personal Consumption Expenditures Price Index (PCEPI), the Fed’s preferred measure of inflation, grew at a continuously compounding annual rate of -0.1% in May, down from 3.2% in the prior month, according to new data from the Bureau of Economic Analysis. Overall, it has grown 2.5% over the past year and 3.8% since January 2020.

Core inflation, which excludes volatile food and energy prices, has also declined. Core PCEPI grew at a continuously compounding annual rate of 1.0% in May, down from 3.1% in April and 4.0% in March.

Prices today are 8.9 percentage points higher than they would have been had the Fed hit its 2% inflation target over the period, according to the Monthly Inflation Report with the College of Business. Earlier this month, members of the Federal Open Market Committee (FOMC) suggested the federal funds rate target range would need to remain at 5.25% to 5.5% for longer than had previously been thought.

“The latest inflation numbers bolster the case for lowering the federal funds rate target. As inflation declines, the real (inflation-adjusted) federal funds rate target increases. To prevent the real interest rate from rising, and monetary policy from tightening even further, the FOMC must lower its nominal federal funds rate target,” said William J. Luther, Ph.D., associate professor and economist in FAU’s College of Business.

When the FOMC set the current target range in July 2023, the PCEPI was growing 3.3% year-over-year, and core PCEPI was growing 4.0%. Both of those rates have since declined to 2.5%. Inflation is 0.8 to 1.6 percentage points lower, but the federal funds rate target range is unchanged, according to Luther.

“Given the progress made on inflation and the current stance of monetary policy, it makes sense for the Fed to begin cutting its federal funds rate target. It must return policy to neutral to avoid putting the economy in reverse,” Luther said. “Falling inflation likely means that the implied real federal funds rate target range has increased over the last 11 months. Estimates of the natural rate have also declined. Together, lower inflation and a lower natural rate of interest imply that the spread between the natural rate and the implied real federal funds rate target has grown. In other words, monetary policy has gotten tighter.”

-FAU-