MNI POLICY: Fed's Rate Cut Timeline Shaken By Inflation Bumps

Sputtering progress on inflation so far this year is eroding the confidence of Federal Reserve officials and potentially nudging back the likely timing of the first interest rate cut beyond market expectations for June.

Two months of hotter-than-expected consumer and producer price readings have raised eyebrows among policymakers seeking assurances that inflation is heading sustainably back to the 2% target. They will comb through the next couple of months of figures to see if the early-year signals were an aberration or the start of a new mini-trend. (See MNI INTERVIEW: Fed Can't Let Guard Down On Inflation-Weinberg)

While the Fed’s latest rate projections still show a median of three cuts for this year, FOMC members generally penciled in fewer cuts for 2024 and subsequent years, even as they raised their year-end core PCE inflation view to 2.6% from 2.4%. Indeed the Fed’s “dots” essentially show a committee split between two and three cuts but increasingly leaning toward two.

There was also a notable increase in the number of officials expressing concern about upside risks to inflation.

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Fed Chair Jerome Powell said in his press conference last week the central bank is “not going to overreact to these two months of data, nor are we going to ignore them.”

Strength in service sector inflation remains a particular concern as so-called supercore readings show little sign of letting up. The six-month annualized rate for February core and supercore CPI climbed 0.3pp, to 3.9% and 5.9% respectively.

This persistence is raising fears that inflation could level off at 3% as goods deflation stalls, posing a threat to price expectations that officials believe are still well anchored despite the hit to consumer and business psychology from three years of outsized price gains. (See MNI INTERVIEW: US Services Firm Despite ISM Miss, Prices High)

Wage growth is still running above 4% by most measures, while the Fed sees 3.5% as a level that would be more consistent with overall price stability, particularly given the feedthrough to the labor-intensive service sector.

R* NORTH STAR

A small but important shift in the Fed’s Summary of Economic Projections was a long-awaited uptick in the median view of the longer-run fed funds rate, seen as a proxy for the neutral rate or r-star.

Where officials think that elusive number lands – the estimates range from under 2.5% all the way to 3.75% – determines how restrictive they actually think interest rate policy actually is.

Many policymakers, led by New York Fed President John Williams, believe the neutral rate has not risen much post-pandemic. That makes policy quite restrictive, with an effective real funds rate around 3%.

But there is a growing camp willing to entertain the notion that the economy has changed in substantive ways post-pandemic, in ways that could make it more prone to overheating and thus requiring more torque from monetary levers. That helps explains why it wasn’t just the long-run median for fed funds that was revised higher but also the expected rate path for 2025 and 2026. (See MNI POLICY: Lively Debate At Fed Over Possible R-Star Rise)

A strong economic and employment backdrop will reinforce the case for patience in cutting rates, with the Fed’s higher-for-longer mantra set for an extension.