MNI INTERVIEW: Hot US Economy Complicates Fed Cut Calculus

A U.S. economy that continues to defy expectations complicates Federal Reserve calculations on when to begin easing monetary policy, not only due to upside risks for inflation but because it also opens up alternative explanations for why inflation has fallen so quickly, Alan Detmeister, who previously headed the wages and prices section at the Fed Board of Governors, told MNI.

Plugging current price trends into the Fed's own models would result in at least one cut by this point. But the FOMC is signaling it does not intend to lower rates until May at the earliest, on concerns that strong payrolls growth and consumer spending could lead to a reacceleration of inflation, Detmeister said in an interview.

"If they were solely focusing on inflation, then it would make sense to be cutting in March. You’ve already seen inflation coming down extremely solidly. Over the last six months, core PCE inflation is below 2%. The 12-month measure is 2.9%, and there are going to be very large base effects pushing down the number in every month through May," Detmeister said.

"So clearly they’re not just looking at the inflation data. They’re looking at the strength of the overall economy and worried about how that could have second-order impacts."

SUPPLY-DRIVEN

An alternative explanation for the immaculate soft landing of the U.S. economy is that inflation has come down because of a positive supply shock that began last year, said Detmeister, a UBS economist. When that runs its course, strong aggregate demand will see inflationary pressures reemerge.

"We had significant supply constraints and supply problems during the pandemic, and the fact you have inflation slowing as well as a strong real economy -- that’s exactly what you would expect if you’re now seeing those improvements in supply," he said.

"Some would take this as suggesting these inflation improvements we’re seeing are temporary. The earlier inflation is due to supply problems -- a swing in the mix of demand toward goods, and a mismatch of capital and where demand was, which itself can lead to inflation because if you have fixed costs in rents and loans, you can’t lower prices as much."

These problems haven't all gone away. Services demand is still running well below its pre-pandemic pace, and goods purchases well above. Shipping routes are shut, but some ports have also expanded capacity. "The longer it continues the less it’s an issue, slowly over time you can change your capital structure to meet that demand."

INFLATION CONFIDENCE

Fed officials say they also seek more conviction that the slowing inflation is sustainable. That could come from several areas. Rent and motor vehicle disinflation are likely to drive disinflation for the next six months, but there's uncertainty over how much further housing inflation will slow, Detmeister said. (See: MNI: US Shelter Inflation Cooldown Seen Limited In 2024)

Inflation also often strengthens from residual seasonality at the beginning of the year, when a large portion of price changes occur in both goods and services, he said. Six-month annualized core PCE inflation could rebound to 2.4% this month before dipping again, he said. He sees the 12-month change falling to 2.1% in the May report, to be released after the June FOMC meeting, and down to 1.8% at the end of the year.

"To some extent it’s understandable that Powell and others would want to wait until you have the January and February numbers in hand to see if early-year price increases are really big this year," he said.