Slowing America’s runaway inflation has been a surprisingly painless process so far. High interest rates make it expensive to get a mortgage or borrow money to start a business, but they haven’t put a damper on economic growth or drastically pushed up unemployment.
However, price increases have been hovering around 3.2% for five months. That flatline is fueling questions about whether the final phase in the fight 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 wrap up 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 affect their view of how many rate cuts are coming this year and next.
The Fed’s most recent economic estimates, released in December, suggested Fed officials would cut interest rates by three basis points by the end of 2024. It has proved stubborn. Some economists believe it is possible that officials will scale back their expectations for a rate cut, predicting only two moves this year.
By leaving interest rates higher for a little longer, officials could keep pressure on the economy, guarding against the risk of inflation returning.
“The Federal Reserve should not be in a race to cut interest rates,” said Joseph Davis, Vanguard’s global chief economist, explaining that the economy held up better than expected if interest rates weighed heavily on growth. and that early tapering risks inflation rising in 2025. “We have an increasing chance that they will not cut rates at all this year.”
Mr. Davis’ team is an outlier in this regard: investors, in general, still see a very small chance that the Fed will keep interest rates at the current 5.3% until 2024.
But markets are steadily revising how many rate cuts they expect. Investors are now betting that central bankers will cut interest rates three times by the end of the year, to around 4.6%. Just a month ago, they expected four cuts, and saw a reasonable possibility of five.
Two major developments have changed these views.
Inflation was more stable than expected. The Consumer Price Index measure beat economists’ forecasts in January and February as services inflation proved persistent and some goods, such as clothing, rose in price.
Wholesale inflation – which measures the cost of purchases made by businesses – was also higher than expected in data released last week. This matters because it feeds into the Personal Consumption Expenditure inflation index, a more lagging measure but one that the Fed is officially aiming for in its 2% inflation target.
Given the data, Fed officials are likely to use this meeting to discuss “whether inflation can continue to decline,” Diane Swonk, chief economist at KPMG US, wrote in a research note.
“The concern is that the low-hanging fruit associated with healing supply chains and falling commodity prices have been picked, while a floor may be forming in service sector prices,” he explained.
The second development is that the economy still has great momentum. Job gains were steady in February, although the unemployment rate accelerated and wage growth is slowing only slowly. If the economy remains very buoyant, it could keep the labor market tight and keep wages rising, which in turn would give companies an incentive to raise prices. That could make it harder for the Fed to tackle inflation in a sustainable way.
The Fed does not want to cut interest rates prematurely. If the central bank fails to deal quickly with price increases, it could convince consumers and businesses that inflation is likely to be higher in the future. That could make it even harder to eliminate inflation down the road.
At the same time, the Fed doesn’t want to leave interest rates high for too long. If it does, it could hurt the economy more than it needs to, costing Americans jobs and wage gains.
Fed officials have been signaling for months that interest rates are being cut soon, but they are also trying to keep their options open on timing and size.
Jerome H. Powell, the Fed chairman, said in recent testimony to Congress that it would be appropriate to cut interest rates when the Fed was confident that inflation had fallen enough, adding: “And we’re not too far from that.”
But several of his colleagues have heard cautious tones.
“At this point, I think the biggest mistake would be to cut rates too soon or too quickly without sufficient evidence that inflation is on a sustainable and timely path,” said Loretta Mester, president of the Federal Reserve Bank of Cleveland. a recent speech. That point has been echoed by other officials, including Christopher Waller, the Fed governor.
Fed officials have another policy plan on their plate in March: They have indicated they will discuss their future plans for their bond balance sheet. They shrink their balance sheet by allowing the securities to expire without reinvestment, a process that takes some of the vim out of the markets and the economy on the sidelines.
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 shrink it to more normal levels to avoid playing such a large role in financial markets. At the same time, they want to avoid shrinking their bonds so much that they risk market ruptures.
George Goncalves, head of US Macro Strategy at MUFG, said he believed officials would want to make a plan to slow the balance sheet runoff first and then turn to rate cuts. He believes 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 was skeptical of the argument that it could prove harder to finish the job on inflation than to start. He believes falling labor costs and housing inflation will continue to slow price increases.
“We can get a little jumpy,” Mr. Feroli said. The idea that the “last mile” will be harder “has a nice rhetorical ring to it, but then you taper off and I’m not convinced.”
