Strong jobs and growth data have significantly diminished the chances of a Federal Reserve interest rate cut in March, and even May no longer has the certainty odds it seemed two weeks ago. While officials are still open to the idea of easing monetary policy, they have rejected the possibilities of an imminent move. We suspect the Fed recognizes that its credibility was damaged by its claim that “inflation is transitory” in 2021, only to have to quickly reverse course with significant rate increases throughout 2022 and 2023. The latest from the Fed wants to do is get it wrong again at a key turning point, it will ease up too soon and too quickly and reignite inflationary pressures. You want to make sure the data is fully consistent with inflation returning to 2% and staying there.
The Federal Reserve’s preferred measure of inflation, the core PCE deflator, is already advancing at the appropriate rate and labor market inflation pressures are easing, based on declining attrition rates and a slowing labor cost index. However, the Fed would ideally like to see a little more slack in the labor market, created by a moderation in growth rates: the “soft landing.” This week’s figures could point in this direction, with retail sales and industrial production the highlights of activity, while consumer price inflation is also scheduled to be released. Starting with the CPI, it has been recording faster month-on-month increases than the PCE deflator, largely due to the greater weighting of housing and vehicles in the basket of goods and services used to calculate the inflation rate. Rents are slowing on the open market, but the way the series is constructed within the CPI report means it takes a long time for those movements to appear in official data. Used car auction prices in Manheim suggest vehicle prices will be a depressing factor in January inflation. We expect a 0.3% month-on-month rise in the core inflation rate, with risks slightly skewed in favor of a 0.2% outcome rather than a 0.4% rise.
Retail sales are likely to be weak, given that auto sales figures already released were poor. The bad weather has certainly played a role, but high borrowing costs for credit cards, auto loans and personal loans for more than 20 years are not helping. There is also growing evidence to suggest that the excess savings accumulated in the pandemic era will support spending. Meanwhile, industrial production is likely to rise due to strong demand for utilities, but the manufacturing sector is likely to remain subdued given the ongoing contraction flagged by the ISM report.
At the January FOMC meeting, FOMC Chair Jerome Powell acknowledged that monetary policy is in “tight territory” and that it will be “appropriate to step back” on this at some point this year. We expect May to be the starting point, at which point we believe the current moderate measures of core inflation will give the central bank the confidence to cut rates. We predict the policy rate will fall to 4% by the end of this year and 3% by mid-2025. This will simply put us closer to neutral territory: the Fed’s view is that 2.5% is probably the average long-term. If the economy enters a more troubled period, such as due to banking stress, there is room for much deeper cuts than we forecast.