Fed rate cuts are now a matter of if, not just when
Another firmer-than-anticipated inflation report delivered a meaningful setback Wednesday to the Federal Reserve’s hope that it could buoy prospects of a so-called soft landing by dialing back some of the past year’s interest-rate increases.
Solid hiring and the prospect that inflation might settle out closer to 3% than the Fed’s 2% goal could call into question whether the central bank will be able to cut rates until much later in the year without evidence of a sharper slowdown in the economy.
A third straight month in which prices were hotter than expected likely sends officials back to an uneasy holding pattern where they wait several more months for either better inflation data or the type of evident economic weakness they were hoping to avoid.
“It definitely makes them less confident that inflation is coming back to the 2% target,” said Alan Detmeister , an economist at UBS who used to run the Fed’s inflation-forecasting division.
Just bumpy, or stuck?
Fed officials including Chair Jerome Powell started the year with the wind seemingly at their backs: Inflation cooled at the end of 2023 faster than most economists inside or outside the central bank had anticipated, particularly given unexpectedly brisk hiring and growth.
Those broad-based inflation declines offered reasons to think maybe, contrary to the conventional wisdom, the proverbial last mile of the inflation battle wouldn’t be difficult— that after declining from 7% in June 2022 to 3% in 2023, inflation might gently fall back to the Fed’s 2% goal without the “pain” in the labor market that Powell had once warned would be likely. (The 7% figure is based on the Fed’s preferred inflation gauge .)
The latest data raises two different possibilities. One is that the Fed’s expectation that inflation continues to move lower but in an uneven and “bumpy” fashion is still intact—but with bigger bumps. In such a scenario, a delayed and slower pace of rate cuts is still possible this year.
A second possibility is that inflation, rather than on a “bumpy” path to 2%, is getting stuck at a level closer to 3%. Without evidence that the economy is slowing more notably, that could scrap the case for cuts altogether.
“Underlying inflation is down. We have made progress. Frankly, we’ve made more progress than I would have expected a year ago,” said Jason Furman , a Harvard University economist. “But we’ve made less progress than anyone was hoping for three months ago.”
‘We’re just being careful’ Indeed, Powell told lawmakers in March that Fed officials were “not far” from being able to gain the confidence needed to lower interest rates by midyear. One or two more benign price readings might have been enough for officials to conclude interest rates could be recalibrated lower.
“We don’t want to have a situation where it turns out that the six months of good inflation data we had last year, that that didn’t turn out to be an accurate signal of where underlying inflation is, so we’re just being careful,” Powell said.
Fed officials often stress that their policy decisions depend on the totality of economic data and not any single data point. Still, the inflation data has loomed larger than ever as of late because with signs that the economy remains on solid footing, Powell and his colleagues had been looking for a credible justification to start cuts.
Threading a needle
The March inflation report wasn’t notable on its own. Prices excluding volatile food and energy items posted nearly the same increase of almost 0.4% in March as they did in February.
But because January and February figures had been stronger than expected, another miss began to surface more perplexing questions, including whether the conventional wisdom is wrong— again—about inflation. Among them: What if the Fed isn’t able to deliver any rate cuts this year, and what if investors are putting too much confidence in the Fed to achieve a soft landing?
“For investors to assume that they thread this needle is a little bit presumptuous, and I think actually quite dangerous,” said Peter Berezin , chief global strategist at BCA Research. “The market has been priced for a soft landing, and if we get either a second wave of inflation or an increase in unemployment that feeds on itself and produces a recession, the market is going to sell off really, really significantly.”
Futures contracts tied to the federal-funds rate show traders see rates ending the year around 5%, according to FactSet, implying just one or two quarterpoint cuts this year. Entering January, traders had expected the Fed to cut interest rates six or seven times.
Many Wall Street forecasters threw in the towel Wednesday on their projection that the Fed would cut rates in June or that officials would make three cuts this year. Economists at Goldman Sachs and UBS now see two cuts starting in July and September, respectively. Analysts at Barclays anticipate just one reduction, in September.
“A June cut was a keystone of our three-cut call. If that goes, we think the first cut will easily slide into December,” said Blake Gwinn , an interestrate strategist at RBC Capital Markets.
Bottom-up or top-down?
Fed officials raised rates aggressively starting two years ago to head off the risk that consumers might expect price gains to continue. Central bankers regard such an outcome as extremely perilous because these expectations can be self-perpetuating, since consumers are more likely to demand bigger raises and be more resigned to paying higher prices.
Because wage growth has continued to slow, Powell and other officials have signaled they are less concerned about signs that the economy is continuing to grow steadily.
Still, the latest data does little to clarify a broader debate inside the Fed over what is driving the inflation process. Some officials and economists outside the central bank have taken a bottom-up approach to inflation. They argue that higher services inflation in recent months reflects the aftereffects of pandemic-related disruptions and not an overheated labor market. Services prices should cool, they say, as labor market imbalances fade.
“What we’ve learned is that some of these lag effects are just very, very long—maybe a lot longer than what we’d anticipated before,” said Detmeister.
For example, price increases have been unusually large for auto insurance , which likely reflects how insurers boosted premiums as the cost to replace wrecked vehicles soared after car prices jumped several years ago. A big increase in wages for hospital workers two years ago appears to be boosting hospital prices now, said Omair Sharif , founder and president of Inflation Insights.
Even though wage growth for hospital workers has declined and auto prices have stopped rising, “they’re continuing to play ‘catch up’ on inflation,” said Sharif. “We could be stuck with elevated inflation in these categories for a while.”
But other Fed officials are skeptical of that bottom-up look and say a top-down approach is warranted. They worry the economy and labor markets will need to slow down more to prevent businesses from pushing along more price increases.
The large increase in inflation in January “wasn’t a story of outliers,” said Dallas Fed President Lorie Logan last week. “The entire distribution of price changes shifted” in the direction of larger increases, she said.
Richmond Fed President Tom Barkin , a former executive at consulting firm McKinsey, said last week he was concerned that even if the most significant price increases were in the rearview mirror, companies and business owners might have found new courage to push up prices to boost revenues.
“A lot of the bottom-up inflation misses that it needs to add up from the top down,” said Furman. “Some things are more expensive because people can afford to buy those more-expensive things.”