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The US Federal Reserve is edging closer to rate cuts
The key factor influencing the global economy over recent years has been the sharp run-up in inflation post COVID, and the subsequent monetary policy tightening to contain the inflationary pressures. After good progress in reducing inflation last year, the start of 2024 has been disappointing following a trio of upside inflation surprises in the US during the March quarter. This week, we finally received some welcome signs of inflation moderation in May in the US and some updated guidance from the US Federal Reserve.
Turning to the inflation details first, the US headline CPI remained flat over the month, helped by lower gasoline prices. More importantly, consumer prices excluding food and energy rose just 0.2% over the month, the softest monthly print since August 2021. In year-ended terms, the core CPI inflation rate fell from 3.6% to 3.4% in May, down from a peak of 6.6% in 2022. This bodes well for a moderation in the core PCE inflation rate, the main inflation rate that policymakers focus on in the US, which now looks likely to ease from 2.8% to 2.6% in May.
The moderation in CPI inflation was broadly based over May. Core goods prices were flat over the month, continuing the trend of benign goods prices following the improvement seen in supply chains across the global economy. More encouragingly, there were signs of moderation in core services CPI inflation over the month, particularly for the so-called ‘super-core’ measure which excludes both energy and the sticky housing rent components. Super-core services CPI fell marginally in May, a sharp improvement after prices rose at a 7% annualised pace in the March quarter. The Fed has been particularly attuned to trends in super-core services inflation as they provide a clearer assessment of domestic pricing pressures, with Fed Chair Powell previously noting that “this may be the most important category for understanding the future evolution of core inflation.” Of course, it is important to remember that this is only a single-print, and further evidence will be required to gain confidence that these service price pressures are dissipating.
This was precisely the messaging delivered by Chair Powell following the FOMC meeting this week. At the meeting, the Fed decided to keep rates unchanged at 5.25%-5.50%, a decision that was universally anticipated given the previous signalling by the Fed and the higher inflation momentum seen at the start of the year. The more important aspect of the meeting was always going to be the updated guidance by the Fed.
In this respect, the Fed sent a clear hawkish message. In its dot-plot projections, the median expectation of the Fed moved to expect only 1 cut in 2024, which would most likely be in December, down from 3 cuts envisaged in March. These expectations were always going to be revised down, but many commentators thought the Fed would shift to an expectation of two cuts for 2024. Looking further ahead, the Fed now expects a faster pace of cuts (four in both 2024 and 2025), such that rates are still expected to reach 3.125% by the end of 2026. The Fed also continued to shift up its long-run expectations for the federal funds rate to 2.8% (up from 2.5% six months ago), although this remains slightly below QIC’s long-run expectation of 3.1%.
The Fed downplayed the weaker GDP growth seen in the US economy during the March quarter and left its growth forecasts unchanged across the forecast horizon. The Fed expects solid growth in the US economy will continue at 2.1% over 2024 and 2.0% in both 2025 and 2026. Driving the reassessment for monetary policy were the upside surprises to inflation earlier in the year, which led the Fed to expect a slower moderation in inflation moving forward. In particular, the Fed upgraded its core PCE inflation forecasts to 2.8% at the end of 2024 (was 2.6%), 2.3% at the end of 2025 (was 2.2%) and 2.2% at the end of 2026 (unchanged).
Notwithstanding the Fed’s revised guidance, we wouldn’t rule out the possibility of two rate cuts this year. Based on the Fed’s current projections, we estimate that a standard Taylor rule with interest-rate smoothing would justify 1.6 cuts by the end of the year. However, in our view, the US economy is likely to moderate more than the Fed expects over the second half of 2024. With US consumers close to exhausting their post-pandemic excess savings buffers, we expect the strength seen in the US consumer over 2023 to ease. To be clear, we also expect a soft-landing in the US economy, but we expect growth to slow to around a 1.7% pace by the end of the year and we expect the unemployment rate to rise slightly quicker and a little higher than the Fed to around 4.3%. With recent strong productivity growth already leading to a sharp moderation in the growth in unit labour costs, an ongoing moderation in super-core services inflation appears likely. As a result, our expectations are for core PCE inflation to reach 2.7% at the end of 2024 and 2.1% at the end of 2025, slightly below the Fed’s current expectations.
In other words, if we continue to receive further promising inflation reports over coming months and signs of softer economic activity, we expect the Fed might have the confidence to ease rates slightly earlier than currently flagged. Current market pricing is more aligned with our view, pricing in around a 70-80% chance of a rate cut by September and two full cuts by the end of the year.
Whether the Fed delivers one or two cuts this year, it is clear the US economy has made considerable progress in lowering inflation. The last-mile down may well prove bumpy, but it is becoming increasingly apparent that demand and supply conditions in the US economy are moving into better balance. As a result, the Fed will not need to keep rates as restrictive as they were in 2023 for too much longer. While the US has experienced a bout of exceptionalism over 2023, it will not be long before they join Canada, the euro area, Switzerland and Sweden in a monetary policy easing cycle.