Fed meets amid concerns that inflation progress could stall

Slowing rapid U.S. inflation has been an unexpectedly painless process so far. High interest rates make it expensive to take out a mortgage or borrow to start a business, but they have not slowed economic growth or dramatically increased unemployment.

Yet price increases have been fluctuating around 3.2 percent for five months. This flat line raises questions about whether the latest phase in the battle against inflation could prove more difficult for the Federal Reserve.

Fed officials will have a chance to respond to the latest data on Wednesday when they conclude a two-day policy meeting. Central bankers are expected to leave interest rates unchanged, but their new quarterly economic forecasts could show how the latest economic developments influence their view on the number of rate cuts this year and next.

The Fed’s latest economic estimates, released in December, suggested Fed officials would cut rates by three quarter points by the end of 2024. Since then, the economy has remained surprisingly strong and inflation, while still down sharply from 2022 highs, has proven stubborn. Some economists think it’s possible officials could adjust their rate cut expectations, predicting just two steps this year.

By leaving interest rates higher for a little longer, officials could continue to put pressure on the economy and guard against the risk that inflation would pick up again.

“The Federal Reserve should not be in a race to cut rates,” said Joseph Davis, Vanguard’s chief global economist, explaining that the economy has held up better than would be expected if rates were to drastically depress growth , and that premature cuts risk inflation will heat up in 2025. “We have an increasing chance that they won’t cut rates at all this year.”

Mr. Davis’ team is an outlier in that regard: Investors in a broader sense still see a very small chance that the Fed will keep interest rates at the current 5.3 percent through 2024.

But markets have been steadily reassessing how many rate cuts they expect. Investors now expect central bankers to cut interest rates three times by the end of the year to around 4.6 percent. Just a month ago they expected four cuts and saw a reasonable chance of five.

Two major developments have shifted these views.

Inflation is stronger than expected. The consumer price index exceeded economists’ expectations in January and February, as inflation in the services sector proved persistent and some goods, such as clothing, rose in price.

Wholesale inflation – which measures the costs of purchases companies make – also came in higher than expected in the data released last week. That matters because it contributes to the personal consumption expenditures inflation index, a measure with a longer lag, but the one the Fed officially targets with its 2 percent inflation target.

Given the data, Fed officials will likely use this meeting to debate “whether inflation can continue to cool,” Diane Swonk, chief economist at KPMG US, wrote in a research note.

“The concern is that the low-hanging fruit associated with the recovery of supply chains and the fall in commodity prices has been picked, while a floor may be emerging under prices in the services sector,” she explains.

The second development is that the economy still has a lot of momentum. Job growth was solid in February, although the unemployment rate rose wage growth only slows down slowly. If the economy retains too much strength, it could keep the labor market tight and wages rising, which in turn would give companies an incentive to raise prices. That could make it difficult for the Fed to reduce inflation in a sustainable way.

The Fed does not want to cut interest rates prematurely. If the central bank fails to quickly get price rises under control, it could convince consumers and businesses that inflation is likely to be higher in the future. That could make it even harder to eradicate inflation over time.

At the same time, the Fed does not want to leave interest rates high for too long. If it does, it could do more damage to the economy than necessary, costing Americans jobs and wage increases.

Fed officials have been signaling for months that interest rates are coming soon, but they are also trying to keep their options open on timing and size.

Jerome H. Powell, the Fed chairman, recently said in testimony to Congress that it would be appropriate to cut rates if the Fed is confident that inflation has fallen sufficiently, adding: “And we are not far from it.”

But several of his colleagues have struck a cautious tone.

“Right now, I think the biggest mistake would be to cut rates too early or too quickly without sufficient evidence that inflation is on a sustainable and timely path,” said Loretta Mester, the president of the Federal Reserve Bank of Cleveland, in a statement. a recent speech. That point was echoed by other officials, including Christopher Wallera Fed governor.

Fed officials have another policy project on their plate in March: They have indicated they will discuss their future plans for their bond-invested balance sheet. They have shrunk their balance sheets by allowing securities to mature without reinvestment, a process that takes a little bit of energy out of the markets and the economy at the margins.

The Fed’s balance sheet grew during the pandemic as it bought bonds in large quantities, first to calm markets and later to stimulate the economy. Officials want to return it to more normal levels to prevent it from playing such a major role in financial markets. At the same time, they want to avoid reducing their bond investments so much that they run the risk of a market burst.

George Goncalves, head of US Macro Strategy at MUFG, said he thought officials would first want to make a plan to slow the deleveraging of balance sheets, and then move on to interest rate cuts. He thinks the first rate cut could come in June or July.

Michael Feroli, the chief US economist at JP Morgan, expects a rate cut in June – and said he doubted the argument that finishing the job on inflation could prove harder than starting it. He thinks cooling labor costs and housing inflation will continue to slow price increases.

“Maybe we’re getting a little nervous,” Mr. Feroli said. The idea that the “last mile” will be more difficult “has a nice rhetorical appeal, but then you bounce back a bit, and I’m not convinced.”