The Problem With Too Long of a Fed Delay?

The latest round of inflation reports has led the Federal Reserve to lower expectations about potential rate cuts. But how long should the Fed wait? We share our views on why a first cut this summer remains our base case.

A recent string of hotter-than-expected inflation prints has caused a complete reversal of market expectations around Federal Reserve (Fed) policy through the rest of the year. Essentially, we swung from pricing six or more cuts in early January to just 1.6 in mid-April. Are we back to square one, then, on inflation and rates? On inflation, our answer is emphatically no. On rates, we are indeed back to waiting for the Fed to get confident enough that inflation is returning sustainably to target. Chairman Jerome Powell has suggested delaying rate cuts. We agree that there is some room to delay, but not that much. June-July remains the ideal window for initiating the rate-cutting cycle and, despite everything, we think June is still best. If the Fed is reluctant to take the inflation “win” by July, it may be harder to claim it during the autumn, given elections and difficult base comparisons.

Are We Back to Square One on Inflation?

In all fairness, the January-March CPI prints were all stronger than expected, even if only modestly so. But we are struck by the extent to which they have been made out to invalidate the substantial and compelling progress on inflation made over the prior year, especially on core personal consumption expenditures (PCE) inflation, the Fed’s target, which went from 4.8% year-over-year (YoY) in March 2023 to an estimated 2.8% in March 2024 (Figure 1).

Not only is inflation lower, but it is also less broad. The early stage of disinflation had indeed been dominated by energy and goods prices, so everyone was careful at the time to not over-celebrate that early improvement. However, that is no longer the case. Measures of inflation breadth or stickiness have not yet normalized, but are much further along the normalization path than even six months ago (Figure 2).

Evidently, saying that there are few areas of intense inflation is not to say that there are none. There are. As discussed in our latest weekly commentary, shelter, car insurance costs, and repair services are largely to blame for recent inflation surprises. But the reality is that these primarily reflect delayed responses to exogenous shocks (supply chains, immigration) that, for better or worse, are insensitive to interest rates in the near term. There is something to be said for allowing time for these responses to work themselves through the system, given that inflation expectations are – by essentially all measures – well anchored. Critically, despite fears to the contrary, wage inflation in many service industries has dramatically moderated. Although services inflation persists, risks of a wage/price spiral are, in fact, minimal.

Finally, the resilience of the economy in general, and labor market in particular, have given rise to a sense that the costs of waiting to cut are negligible. On a month-to-month basis, that can certainly be argued. But that very argument can also be turned on its head by focusing on the lags with which policy operates. So, if it does not hurt to hold steady, how much does it hurt to cut 25 basis points?

It is our view that there is more slack in the labor market than the headlines suggest. The payroll numbers only tell half the story: that we are creating jobs. But the other half is that we are now creating more lower-quality, part-time jobs, which a sign of waning labor demand. Average weekly hours have now receded to levels not usually seen outside recessions. And given the steady rise in the labor underutilization rate, we suspect this is not a choice on the part of workers (Figure 4).

Take the Win Now or Risk Being Constrained Later

There are two main reasons why we believe that June-July remains the ideal window for initiating the rate-cutting cycle. Of the two, July now appears more likely, but June has some advantages. There will be two more inflation and employment reports by the time of the June 12 Fed meeting, and only one more of each by the July 31 meeting. There is a risk of over-reliance on that last set of data to secure the confidence needed for a summer cut. Given the vagaries of recent data, what if the third set looks worse than the second? Then, even if there is a desire to cut at that point, it becomes a little harder to explain the move.

Most importantly, we anticipate the core PCE inflation rate (YoY) to bottom out in May, then inch modestly higher from there before retreating visibly again in early 2025. This is simply a reflection of incredibly difficult base effects (we had four months of 0.1% month-over-month readings in the second half of 2023). Add the election schedule into the mix and, even though we have no doubt that the Fed would cut in either September or November if the data looked compelling, why taint the first cut with too close of an association to such an event?

The Bottom Line

Overall, we still anticipate a summer rate cut, and we still believe that three to four cuts are possible this year. It is a tough and (very) lonely spot at the moment, but we know how much can happen – not only in the two months left until the June meeting, but in the eight remaining months of 2024.