How fast is fast? Or how slow is slow?
Going into the new year, the widespread expectation among economists and Wall Street was that the Federal Reserve would cut interest rates sometime in the first half of the year — maybe in March, maybe in May, but sooner rather than later.
Two years after the Federal Reserve began raising interest rates to their highest levels in decades, that long-awaited moment had the potential to brighten consumer confidence, boost company valuations and improve corporate financing opportunities. It was called a “pivot party,” and everyone was invited.
But after a series of better-than-expected inflation data over the next three months, financial markets predicted the Fed would cut rates once near the end of the year, or not at all, believing that as long as inflation remained moderately elevated and employment was growing, the Fed would see little merit in such a move.
Mortgage and auto loan rates are trending upward again, and the pivot party appears to have been canceled, though some experts argue it has only been postponed, leaving forecasters divided on what the rest of the year will hold.
Camp 1: Inflation is getting under control
Some market analysts and bank economists have argued that a rate cut is still on the table, given the April jobs report that suggested a cooling labor market and slowing wage growth.
These analysts generally argue that current inflation readings are exaggerated due to lagging indicators that reflect cost pressures from a year or more ago that will likely subside over the summer. They also believe that the diffusion process of price stabilization, formally known as disinflation, is on track, although it could face setbacks (especially from an oil shock).
The Fed's go-to inflation gauge, the personal consumption expenditures index, rose 2.7% year-on-year in March, well below a peak of 7.1% expected in June 2022. But growth in that index and the closely watched consumer price index has slowed this year, hindering efforts to hit the Fed's official 2% target.
Skanda Amarnath, executive director of Employ America, a workforce-focused group that tracks inflation data and Fed policy, was among those who initially expected a spring rate cut. In a recent newsletter, he wrote that the first quarter was “filled with a series of inflation surprises, from well-known underlying issues like auto insurance to lesser known ones like financial advisor management fees,” but that “that doesn't mean the deflationary process is over.”
“We remain optimistic,” Amarnath said, noting that recent inflation “deviations have been marginal after all,” adding that “the first rate cuts are most likely to come in September.”
Research teams at some of Wall Street's most influential firms also maintain they expect inflation to gradually subside and that a series of interest rate cuts is coming.
As for rate cuts this year, “we remain bullish on our outlook for three rate cuts,” Morgan Stanley's U.S. research team, led by Ellen Zentner, said in a client note last week, “but we are delaying the start of these cuts until September.”
Goldman Sachs expects two rate cuts this year, in July and November.
These predictions are based on the idea that while the Winter Pivot Party may be over-enthusiastic, the recent pessimistic commentary has gone too far.
Camp 2: The labor market remains overheated
Corporate earnings reports last month revealed a range of companies losing sales to customers who are tired of inflation and becoming pickier, even as some companies enjoy salary increases and investment income that have them spending on more expensive services and products.
Supply chains and energy markets have stabilized after being disrupted by the pandemic and European war, easing some price pressures, but the Fed “hasn't done enough to really kill the consumer to slow demand-side inflation,” Lindsay Piegza, chief economist at Stifel Financial, said in a recent interview with CNBC.
The uncomfortable truth, according to a consensus in the financial industry, is that this period of abnormally low layoffs may need to end in order to fully tame wage growth and ultimately inflation.
“Labor conditions remain favorable and there is no reason to expect inflation to slow significantly going into the end of the year,” argued Jose Torres, senior economist at Interactive Brokers.
He said the strong economy is “structurally driving wage inflation” and that employers are still choosing to cover those costs by raising prices where they can. As a result, Torres concluded, without rising unemployment, hitting the Fed's inflation target “is nearly impossible right now.”
He doesn't think the Fed will start easing interest rates any sooner than next year.
Most economists who have examined the data agree that a continued willingness to pay for more expensive things — or “price insensitivity” — is part of what's keeping inflation going.
Torsten Slok, chief economist at Apollo Global Management, argues that the upper middle class and the wealthiest are especially fueling rising prices for services, and inflation in general, even as companies report that lower-income customers are skimping on savings, looking for bargains and trading up for lower-priced items.
He expects there will be little progress on future inflation indicators and the Fed will not cut interest rates this year.
“Thanks to the strong stock market rally and big cash flows from high-yield savings accounts and bonds, U.S. households have more money to travel by air, stay in hotels, dine in restaurants, and attend sporting events, amusement parks and concerts,” Slok said in a research note.
Wild card: Housing costs
Preston Caldwell, chief U.S. economist at financial services firm Morningstar, said the firm “still expects inflation to return to essentially normal in 2024” and that interest rates would be cut by the beginning of the fall.
He said this forecast was based mainly on the expectation that the government's gauge of rental inflation – which is responsible for much of the recent above-target inflation – would soon fall in line with recent more moderate private sector gauges.
“The latest data still strongly suggest an inevitable decline in housing inflation, but the exact timing remains unclear,” Caldwell argued.
Diagnosing the direction of a big component of the Consumer Price Index, “owner-equivalent rent” — an estimate of how much homeowners, who make up two-thirds of all households, would pay if they rented their homes — has vexed forecasters. Since early last year, various experts have incorrectly predicted when it would fade as a driver of inflation.
Harvard economist Jason Furman describes owner's equivalent rent as “the implicit rent that you pay to yourself each month as a homeowner.” This tends to confuse homeowners, especially those with fixed mortgage payments, who think of their home as an asset rather than a service they provide to themselves. It's a topic of debate among experts.
The latest Consumer Price Index put inflation at 3.5% over the past year. An alternative measure used in other major developed countries that doesn’t include owner-occupied equivalent rents suggests the U.S. economy has been running slightly below or above the Fed’s inflation target since June. But few expect officials to change their chosen inflation metric this quarter.
So a wait-and-see attitude prevails, with high interest rates persisting in the meantime, and the timing, sooner or later, remains unclear.