The Federal Reserve’s battle against inflation had gone better than expected until it recently got bogged down. Thus, the effort to combat inflation can’t be called a victory just yet.
Though the initial predictions for Fed rate cuts for 2024 ranged from three to six, expectations have shifted dramatically with the market now pricing in fewer than two cuts.
Consumer prices have fallen from the highs of June 2022 but remain above the Fed’s 2% target for the inflation rate. Going that final mile — from 3.0% to 2.0% — could be the toughest part of the journey.
Why Won’t They Cut?
If the Fed doesn’t cut this year, it will likely be because inflation isn’t falling as quickly as anticipated by the central bank’s officials and the economy remains positive. Much of the recent decline in inflation has occurred in the consumer-goods sector, where prices have been falling at the fastest pace in nearly 20 years.
One might think inflation in the range of 2.5% to 3.0% would be close enough for rate cuts, but the Fed has repeatedly stressed the importance of that 2.0% goal. In the pre-pandemic era, when disinflationary pressures were the problem, Fed officials felt that inflation rates of 1.5% or 1.6% were too low. So, we should probably assume that 40 or 50 basis points above target is, therefore, too high for the Fed to act. (A basis point is 1/100th of a percentage point.)
While easing inflation means that Fed rate cuts this year are back on the table, whether they happen will likely depend on inflation reports showing continued improvement. Still, analysts are not expecting the first possible rate cut to come any earlier than September.
Home and Car Costs
Both shelter costs and gas prices are among sticky factors that are keeping inflation from going lower: the two accounted for more than 70% of the increase in prices overall, according to the Bureau of Labor Statistics. Gas prices rose 2.8% in April, which was unsurprising given recent increases in oil prices. But things may be changing with shelter costs: Though stubborn housing prices increased, rents grew at their slowest rate in almost two years, signaling to economists that prices may be on their way down. Higher home prices may have a greater impact on rental inflation than in the past, given recent changes in data-gathering methodology.
Outside of housing, service sector inflation is headed in the wrong direction, climbing at an annualized rate above 6.0% over the past six months. This is largely a function of solid wage growth due to a strong labor market. The U.S. unemployment rate has moved up slightly to 3.8%, but that’s still near a 50-year low.
Data Will Decide
The Fed’s decision on rate cuts will be data-dependent, with a focus on progress in inflation and potential softening in labor-market conditions. Investors have been trying to ascertain what exactly the Fed will do at the remaining five Fed meetings this year. Obviously, the policymakers’ data dependence remains on full display.
We have seen neither a full-blown recession nor a credit purge beyond the margin. There continues to be a bifurcated economy in which lower-income households and smaller companies are struggling but higher-income households and larger companies are doing just fine.
Certainly, the labor market and inflation data have provided the Fed with no urgency to consider easing monetary policy anytime soon, and they have also called into question whether any rate cuts are needed at all. As a result, the voting members apparently believe they can just sit back and be patient.
Warmer-than-expected inflation readings earlier this year dented expectations for cuts in 2024, but April’s consumer price index, which was in line with expectations, restored some confidence.
Why Might They Cut?
The most recent consumer price index data follows news that the economy grew less than previously thought to start the year. Gross domestic product (GDP) expanded at a revised 1.3% annualized pace in the first three months of 2024 versus the prior estimate of 1.6%.
Consumer spending, which accounts for more than two-thirds of U.S. economic activity, increased by 0.2% in April after a downwardly revised 0.7% rise in March. Revised gross domestic product data showed consumer spending moderating to a 2.0% pace in the first quarter from the brisk 3.3% pace in the October-December period.
The personal-consumption expenditures price index (PCE) was in line with the expectations of economists. The May reading was also 2.7%. This core index, which is the Fed’s favorite inflation indicator and removes volatile food and energy prices, rose 2.8% over the past 12 months. That was slightly higher than the 2.7% economists had expected. On an annual basis, services inflation is running at 3.9%, while goods inflation is nearly flat at 0.1%.
Conclusion: Watch the Data
The consensus is for no change to rates before September, though more recent data has sparked renewed optimism that multiple rate cuts might be in store before the year ends.
Every data point matters. The Fed meeting in June is consequential in a number of ways, not the least of which is that it will provide the agency’s leaders with the opportunity to update the set of economic projections. The March set of projections still had several rate cuts in the forecast for 2024. We can anticipate an adjustment to that expectation based on stubborn inflation data; however, we still think the Fed will forecast one or two cuts this year.
If the Fed is able to cut slowly as a result, then that will be good for markets. However, if consumer spending – and the economy – slows too quickly, then corporate profits and stock prices will go down much more quickly than the Fed will be able to cut rates.
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