After spending nearly two years on a single-minded mission to stamp out soaring inflation by sharply raising interest rates, the Federal Reserve finds itself with a far more gratifying dilemma as it kicks off 2024: Figuring out when to start cutting rates.
Inflation has been coming down more rapidly than Fed officials anticipated following a pandemic-induced spike in prices even as the economy and labor market have remained astonishingly resilient. Leather Machine Cutter
At a two-day meeting that starts Tuesday, the Fed is expected to hold its key short-term rate steady at a 22-year high of 5.25% to 5.5% for a fourth straight meeting. Yet some economists think the Fed will begin lowering the benchmark rate as soon as March and that means it could signal its intentions at this week’s gathering.
Such a move likely would further propel an S&P 500 stock index that hit a record high last week on the prospect of a continued inflation slowdown and Fed rate cuts.
Several top forecasters, however, say the central bank instead will keep its options open by affirming that it’s done hiking rates without providing a sign that a drop in rates is imminent.
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“The (Fed) will likely aim to keep a March cut on the table without sending a decisive signal,” Goldman Sachs economist David Mericle wrote in a note to clients.
Markets that predict movements in the federal funds rate think a March cut is a close call, reckoning there’s about a 46% chance of such a move. All told, markets are projecting six rate decreases this year to a range of 3.75% to 4%, double the amount forecast by the Fed last month.
Although Mericle believes the Fed will start paring back the rate in mid-March, he says Fed Chair Jerome Powell will probably note that officials will base their decision on two additional months of inflation data before that meeting.
Economists broadly agree the Fed will almost certainly remove from its post-meeting statement an assertion that the “extent of any additional (rate increases)” will depend on the delayed effects of prior rate hikes and economic and financial developments. In other words, the statement should solidify Powell’s comment in December that rate increases are likely over.
Instead, the Fed may refer to any “adjustments” to the key rate, indicating a cut is at least just as likely as a hike, Barclays wrote in a note to clients.
Yet deciding when to do a complete 180 and start chopping rates is trickier.
Traditionally, the Fed reduces rates to jolt an economy that’s slowing or in recession. That’s not the case, at least not yet. Although high interest rates have pushed up the cost of mortgages and other consumer borrowing, the economy grew a sturdy 3.3% in the fourth quarter and a solid 2.5% for all of 2023 as consumer spending stayed strong.
Many economists expect growth of just under 2% this year, slightly below the pre-pandemic pace, though some forecasters still think a mild recession is likely.
As a result, there’s no urgency for the Fed to reduce rates, Mericle says.
At the same time, the Fed’s preferred inflation measure – the personal consumption expenditures index – rose 2.6% annually last month, down from a high of 7% in summer 2022. A core measure that excludes volatile food and energy items and that the Fed watches more closely slipped to 2.9%, the lowest since March 2021.
While those readings are still above the Fed’s 2% target, core inflation each month has been running below 2% on an annualized basis since June, Barclays wrote in a note to clients.
“Based on these measures, the (Fed’s) mission to return inflation to 2% appears to be accomplished,” Barclays said.
That means that after adjusting for inflation, the Fed’s key rate is already more restrictive than the Fed would like, Barclays says. And so theoretically the Fed should trim it to avoid hampering the economy more than necessary to ensure inflation keeps drifting lower.
On the other hand, there are risks that inflation hasn’t been vanquished yet.
A big reason that inflation has eased more rapidly than expected is that average pay increases – which feed into inflation – have slowed as a rise in immigration has boosted the pool of available workers, Barclays says. But there are signs the increase in the labor supply has peaked. Last month, the labor force shrank by 676,000 and yearly wage growth ticked up to 4.1% from 4% the previous month.
There’s also a risk that supply-chain snarls that triggered inflation in the early days of the pandemic could flare again because of military conflict in the Red Sea, Barclays says.
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And while personal consumption expenditures inflation is close to the Fed’s goal, a different inflation measure, the consumer price index, was up 3.4% annually last month and the core consumer price index rose 3.9% – still well above the Fed’s target.
The Fed, in turn, will likely take a wait-and-see approach this week, economists say.
Gasket Cutter The Fed “will not tip its hand on when it expects to cut,” Ryan Sweet, chief U.S. economist of Oxford Economics, wrote in a research note.