Fed weighs future rate cuts as inflation picture looks murky

The Federal Reserve entered 2024 riding high, buoyed by six months of encouraging inflation reports, and signaling three interest rate cuts this year. Just a little bit later, the story isn’t looking so clear-cut.

First, inflation came in hotter than expected in January. Economists and policymakers called it a one-off, citing seasonal glitches and other data quirks that often mess with the start of the year. But then February data ticked up slightly, too, raising questions about whether this all amounts to a few bumps in the road – or the beginning of a more worrisome trend.

Policymakers didn’t have all the answers by the time they convened for their March meeting on Tuesday and Wednesday. Fed officials aren’t concerned anymore that inflation will again surge to 40-year highs or threaten the entire economy. Instead, the question is whether the last mile of the central bank’s fight is colliding with a sticky reality: that inflation could settle just above normal levels and keep victory out of reach.

“Did this [inflation] report knock us from the paradigm of, ‘Okay we’re cutting, but when?’ into the paradigm of ‘Are we cutting at all?’ I don’t think it has, and I don’t think it should,” said Michael Strain, director of economic policy studies at the American Enterprise Institute, a right-leaning think tank.

“But at the same time, I don’t think we should downplay the significance of this. This is evidence of inflation trending up. And that is problematic.”

This week at least, no one expects central bankers to overhaul their fight. Officials are practically guaranteed to hold rates at the current level of between 5.25 and 5.5 percent. And while policymakers are slated to debate the fate of the Fed’s vast balance sheet – namely, the pace at which they reduce the Fed’s more than $7 trillion in government bond holdings – that discussion has been a long time coming.

More telling will be how Fed Chair Jerome H. Powell characterizes the economy at a news conference Wednesday. Officials are also slated to release fresh projections showing what they expect for the economy and how many rate cuts they have penciled in for this year. The most recent forecasts from December included three cuts in 2024. If officials trim that estimate down to two, it will mean they are growing less confident that inflation is reliably on its way down to a more normal 2 percent. (Using the Fed’s preferred metric, inflation was 2.4 percent in January over the year before.)

Powell has long said any decisions depend on how the economy evolves. But he has also suggested that there’s been enough progress on inflation that cuts aren’t too far off, and expectations are building that they could begin sometime this summer. Powell and his colleagues are just looking for more reassurance that the time is right.

“We want to see just a bit more evidence so that we can be confident,” Powell told the House Financial Services Committee earlier this month. “We don’t want to have a situation where it turns out that the six months of good inflation data we had last year, that that didn’t turn out to be an accurate signal of where underlying inflation is.”

Some analysts wonder if the Fed might need to adjust to a new sense of what inflation should be. Ernie Tedeschi, who until recently was chief economist at the White House Council of Economic Advisers, said central bankers have to consider the ways peoples’ consumption habits, housing preferences and more have fundamentally changed since the pandemic. That could affect long-term trends around inflation, too. If, for example, people permanently spend more money on goods rather than services – like buying at-home workout equipment instead of paying for a gym membership – that could affect what “normal” inflation looks like.

“The Fed is going to have to be flexible about thinking about the new equilibrium. What does inflation look like now versus pre-pandemic?” said Tedeschi, now a research scholar at Yale and a visiting fellow at Georgetown University’s Psaros Center for Financial Markets and Policy. “Maybe the 2 percent of the post-pandemic era doesn’t look like your dad’s 2 percent.”

To get a sharper sense of what’s happening with inflation, economists and policymakers splice the numbers in various ways. For example, officials prefer to strip out more volatile categories like food and energy to get what’s known as a “core” reading. They will also look separately at what’s happening with goods (such as costs of electronics or furniture), services (medical care) and housing (namely, rent).

Goods inflation has made the most progress, cooling considerably last year as supply chains cleared up. But in February, monthly core goods prices rose for the first time since May, climbing a slight 0.1 percent after dropping 0.3 percent in January. Clothing and used cars were among the categories that rose slightly.

In an analyst note, economists at LH Meyer/Monetary Policy Analytics argued that down the line, it may be best not to expect a lot more easing on the goods front because much of it has already moved through the pipeline.

“It’s been clear that we shouldn’t expect core goods to continue to pull so much weight in bringing down core inflation the rest of the way to 2%,” the firm’s analysts wrote last week.

Meanwhile, the Fed is looking for more relief on services inflation. Shortages in the labor market drove up wages in 2021 and 2022, which in turn pushed up costs for things including leisure, hospitality and entertainment. But even as employers keep hiring and wage growth has simmered down, the Fed hasn’t seen as much progress as it wants.

In January, one key measure of services inflation rose by a discouraging 0.8 percent. And even while that month’s data was seen as an outlier, February still posted a more moderate 0.5 percent increase.

Then there is housing, which continues to be a major driver of overall inflation. Policymakers and economists argue that the official statistics in the consumer price index are delayed and aren’t reflecting real-time measures, which show rents either stabilizing or falling in major cities.

But experts still thought the shift would be more pronounced by now. It all matters because housing costs make up a large share of overall inflation, so the Fed won’t be able to wrestle price growth to normal levels until housing cools, too.

“We think that’s coming, and we know it’s coming,” Powell said in January. “It’s just a question of when and how big it’ll be.”

Powell’s upcoming remarks could shed light on how he’s reading inflation dynamics, and when cuts could come as a result. Financial markets have so far coalesced around an initial June cut, but that could still get pushed back if upcoming inflation reports bring more unwanted surprises.

Wendy Edelberg, director of the Hamilton Project and a senior fellow in economic studies at the Brookings Institution, noted how Powell and others officials have sought more balance on goods and services inflation before they trigger a rate cut. “That’s going to be a while before that happens,” Edelberg said. “How are we not six months away?”