The Federal Open Market Committee (the Fed) is in a tough position. Core inflation, which excludes volatile food and energy prices, has fallen dramatically and is now approaching its long-term average. The Fed was ready to cut short-term interest rates early in 2025. But now the Fed has been reticent to lower the Fed Funds interest rate from the present target rate of 4.50% due to caution about tariffs’ uncertain inflation impact. Moreover, core CPI comparisons become difficult over the next few months. The June 2024 core CPI was up only 0.09% and July 2024’s was up only 0.19%. As these roll off the year-over-year core CPI calculation, it will appear that inflation is rebounding. Tariffs and the tougher comparisons feed policy noise. But there is a way to cut through the noise and discern which Fed mandate may win – employment or inflation.
The Fed’s caution has put them behind on their interest rate cutting cycle. Historically, the Fed Funds rate has averaged approximately 20 basis points above Core CPI. Today (7/1/25), Fed Funds is 173 basis points above Core CPI.
Now the major issue is that the economy is starting to slow. Unemployment has risen 1% off the bottom, while wage growth has slowed from over 7% to under 4%. The consumer appears shaky as consumer confidence is at the low end of the 10-year range, retail sales are slowing, and nearly every housing indicator is weak. Finally, leading indicators of economic growth such as ISM (Institute for Supply Management) new orders, building permits, consumer expectations, hours worked, and initial jobless claims are all somewhere between tepid and weak.
The Fed has two mandates – maximum employment and stable pricing. If the economy slows, the employment mandate will be in jeopardy. If inflation reignites, the price stability mandate is at risk.
As the economy softens and the Fed confronts this potential inflation pop, which mandate will win – will they keep rates high due to inflation or reduce rates due to economic weakness? How far behind is the Fed? Where do we find clues for these answers?
Although there are plenty of sources for opinions, most of them are consistently wrong. The media consensus had you thinking the Fed would cut rates multiple times by the middle of 2024, continuing into 2025. That consensus shifted to nearly zero future cuts in early 2025. Economists seem to change their minds weekly, as they follow every economic uptick or downtick. Even the Fed itself has a noticeably poor track record in predicting economic peaks and troughs. So what is the best source? The answer is a source that hides in plain sight – the bond market.
I am regularly asked which metrics I review before markets open. Equity futures? The dollar? The first metric I review each day is the U.S. interest rate yield curve, with a focus on the 1-month, 2-year, and 10-year yields. Not only do their daily movements provide an indication of how our equity asset classes may perform that day, but over time they indicate the probable future of economic strength and weakness, along with future Fed interest rate policy.
How have yields provided these clues about the economy and Fed policy in the past?
The following chart is a great indication of how the 1-month U.S. T-Bill yield has shown investors a hint about the future Fed Funds rate. The chart spans one-year, with the effective Fed Funds rate in green and the 1-month T-Bill yield in purple. Notice the action of the purple line prior to movement in the green line. Essentially, the 1-month T-Bill is showing you exactly what the Fed’s interest rate strategy will be in the future.
Source: FactSet
For example, in August of 2024, when many market participants were talking about the Fed delaying reducing interest rates and even potentially increasing rates, the 1-month T-Bill yield started to fall from nearly 5.4% to 4.7% before the Fed reduced interest rates. The same sequence was seen in October and November prior to Fed cuts. Now, after the 1-month T-Bill yield was within a few basis points of the Fed Funds rate from mid-December to mid-May, the 1-month yield has started to fall. This indicates the Fed will lean more toward protecting economic growth versus fighting inflation if forced to choose.
From here, we can follow the 1-month T-Bill yield to provide an indication of which Fed mandate will win, if and when the tough inflation comparisons frighten investors over the next few months. When this happens and the media posts headlines about “Inflation’s Return” and “The Continued Fed Pause”, instead of believing the headlines, find out what the smartest investor in the room thinks – the bond market.
