Recent economic data suggests the US economy grew solidly while price pressures eased, but the Fed remains cautious about rate cuts.
The latest economic data released this week showed that the U.S. economy grew at a healthy pace in the latter half of last year, while Americans saw significant relief from rising prices. This suggests that interest rate hikes are likely over, but Federal Reserve officials are being careful in their approach to easing monetary policy.
The Federal Open Market Committee (FOMC) is widely expected to keep its benchmark interest rate unchanged at the conclusion of its January 30-31 meeting next week. The meeting is anticipated to be relatively uneventful, with no economic projections or updates on the forecast for three quarter-percentage-point rate cuts in 2024.
However, with the core personal consumption expenditures (PCE) price index – which excludes the more volatile costs of food and energy – slowing to 2.9% year-over-year in December, economists and analysts do expect to see hints that Fed officials are starting to consider when to implement rate cuts.
In the official statement, the Fed has been using the term “elevated” to describe inflation. Jay Bryson, chief economist at Wells Fargo, says he wouldn’t be surprised if the committee dropped that word following Thursday’s data release that showed that for the second quarter in a row, core PCE came in at a 2% annualized rate.
Policymakers have indicated that they expect to cut rates before the central bank reaches its inflation target of 2%. But if that’s the case, shouldn’t investors and consumers expect rate cuts soon?
Instead, Fed-fund futures are now pricing in only a 46% chance that the central bank will reduce its benchmark interest rate during the March meeting. Expectations have shifted to cuts at the May or even June meetings.
Central Bankers Tread Cautiously
Central bankers’ desire for caution in determining the timing of rate cuts stems from the fact that the ongoing decline in inflation has, so far, coincided with robust economic growth and a strong labor market. This potentially makes the Fed’s path toward achieving their goals more complex and risky.
Fed officials are not yet convinced that inflation will continue to slow on a sustained basis, and there’s evidence to support their caution. With the U.S. economy still showing signs of resilience, cutting rates too aggressively poses a significant risk of stalling or reigniting inflation.
Much of the disinflation that’s occurred so far has been in goods prices, as supply chains have normalized and transportation costs have come down, says Veronica Clark, economist at Citigroup. There’s likely some additional pressure that could come out of goods prices—such as in used and new car costs—but much of the progress here has already been made.
Yet, much of the inflation in the service sector has remained more persistent, and there’s some risk that inflation could stall above the Fed’s target.
The vast majority of economic data is also not forward-looking and subject to revisions, making it difficult to predict future trends. For example, the Bureau of Labor Statistics recalculates its seasonal adjustment factors each January, potentially changing the picture on inflation trends – as was the case last year.
Healthy wage-growth trends also pose a risk. If the Fed eases monetary policy too soon and goods prices stop falling, it could stall the progress on inflation or even cause prices to rise again because underlying wage growth is still too strong, says Joe Gagnon, senior fellow at the Peterson Institute for International Economics.
The big question for Fed officials, Gagnon says, is whether wage costs will eventually slow even if unemployment remains low. Gagnon believes it won’t, and instead, wage growth won’t slow until the U.S. unemployment rate reaches at least 4%. In December, the unemployment rate was still just 3.7%.
Balancing Act for the Fed
Wage growth and a steady supply of jobs have helped fuel consumer spending. And it was those purchases, along with continued strength in government spending, net exports, and inventories, that helped drive overall gross domestic product (GDP) growth. Real GDP growth rose at a 3.3% annualized rate in the fourth quarter, a surprisingly strong follow-up to the 4.9% surge seen in the third quarter.
While that robust economic growth is not expected to continue – economists surveyed by FactSet expect GDP growth to slow considerably to 0.8% in the first quarter – last year did prove that it’s not wise to bet against U.S. consumers.
