What's the rush?
With solid growth, sticky inflation and surging stocks, the Fed is in no hurry to cut rates.
Bottom Line
The S&P 500 rallied 10% in the first quarter, its best since 2019. Stocks ultimately reflect the strength or weakness of economic and corporate earnings data, both of which have been solid. This morning, the Bureau of Economic Analysis revised fourth-quarter GDP growth from 3.2% to a final gain of 3.4% on the back of a rise in personal consumption from 3.0% to 3.3% and robust spending on services. In addition, the University of Michigan sentiment index soared to a stunning 79.4 in March, nearly a 3-year high. Next week’s payroll data should be solid, as the March survey week for initial weekly jobless claims is low, at 212,000. Finally, fourth-quarter corporate revenues and profits rose about 4% and 8% year-over-year (y/y), respectively, with more gains expected in the first-quarter reporting season.
What’s the Fed’s take? Reflecting on the recent FOMC meeting at the Economic Club of New York last night, Federal Reserve Governor Chris Waller said, “It is prudent to hold this rate at its current restrictive stance for perhaps longer than previously thought to help keep inflation on a sustainable trajectory toward 2%,” Waller explained. He pointed to strength of the domestic economy and resilience of the labor market as reasons that, “the risk of waiting a little longer to ease policy is small and significantly lower than acting too soon and possibly squandering our progress on inflation. In my view, it is appropriate to reduce the overall number of rate cuts or push them further into the future in response to the recent data.”
Is Waller a lone wolf? While the Fed did not cut interest rates last week, its quarterly update of its Summary of Economic Projections reiterated the intent to issue three quarter-point cuts this year. Internally, however, Fed officials appear split on this critically important decision. Nine of 19 members projected two cuts or less (up from six in December). Raphael Bostic, the high-profile president of the Atlanta Fed and a voting member of the FOMC, said recently he anticipates lowering interest rates just once this year.
Different policy direction On the other side of the opinion spectrum is Larry Summers, Secretary of the Treasury under President Clinton and director of the National Economic Council under President Obama. Summers announced in mid-February that, “there’s a meaningful chance—maybe it’s 15%—that the next move is going to be upwards in rates, not downwards.”
Sharp dichotomy Earlier this year, the consensus view on Wall Street called for upward of seven cuts in 2024, with the first cut expected at the last week’s FOMC meeting. That didn’t happen, of course, and the herd has drifted toward the three-cut forecast.
Stubborn inflation The core Personal Consumption Expenditures Index (PCE) peaked at 5.6% in February 2022 and declined to 2.8% in January 2024. But it rose 0.4% month-over-month (m/m) in January, which annualizes to 4.8%. Tomorrow’s February results are expected at 2.8% and 0.3%, respectively. At last week’s FOMC meeting, the Fed increased its estimate for 2024 core PCE inflation, which strips out volatile food and energy prices, from 2.4% in December to 2.6%. Pressure from housing, energy and food costs and rising wages seemed to have sapped policymaker confidence that inflation will inexorably decline to their 2% target.
Housing still expensive After nine consecutive quarters in recession (as mortgage rates nearly tripled from 2.8% in February 2021 to 8.1% in October 2023), residential construction contributed positively to GDP in each of the last two quarters. Mortgage rates have declined to 7.2%, while the Housing Market Index has soared 50% over the past four months, from 34 last November to 51 in March.
The price of new and existing homes surged 60% and 56%, respectively, from pandemic lows in 2020 to record highs during 2022. While prices have certainly moderated during 2023, they are still 29% and 44% higher, respectively, on a net basis. Because housing is the largest and most important asset for most people, and because shelter accounts for about 36% of the nominal Consumer Price Index calculation, housing inflation remains problematic.
Energy prices higher Crude oil (West Texas Intermediate, or WTI) has risen 21% over the past three months to $83 per barrel. Increased volatility in the Middle East, continued OPEC production cuts, the shortfall of 350 million barrels in our Strategic Petroleum Reserve, dollar weakness, and growing confidence in the U.S. soft-landing thesis have contributed to this improvement. We’ve been forecasting a rally in crude to $80-90 this year, with a potential spike to last September’s high of nearly $94 per barrel. Lagging retail gasoline prices have risen nearly 16% from $3.06 per gallon last December to $3.54 now. We could see gas prices approaching $4 per gallon later this year.
Food prices still elevated During the pandemic, kinks in the nation’s food supply chain, a shortage of workers due to illness and school closures, and a sharp spike in wages combined to send food prices soaring 6% in 2021 and 11% in 2022, as companies raised their prices to maintain their profit margins. While food inflation has moderated to 2.2% in February 2024, food prices are still 20% higher than pre-pandemic levels. As they attempt to deflect attention away from their own fiscal policies, the Biden administration’s charges of price gouging and shrinkflation are not resonating.
April fools? The minimum wage for fast-food workers in California will surge to $20 an hour on April 1, a 25% increase from the Golden State’s broader $16 an hour minimum wage currently. These restaurants will need to increase prices 2% for every $1 increase in the minimum wage to maintain profit margins. So, companies are increasing their use of technology to reduce hours worked and headcount, and they are also closing stores in California and looking to expand in more business-friendly states. This situation is a microcosm for businesses across the country, resulting in higher inflation, lower profits and slower economic growth. Average hourly earnings, for example, rose 4.3% y/y in February, while the Fed needs to see this metric decline to 3% on an annualized basis.