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Written by; Eric Winograd
Improving news on the inflation front will likely spur the Fed to kick off rate cuts earlier than we previously projected. This should begin to lift the pressure from the US economy and keep a soft landing as the most likely scenario.
Earlier Fed Rate Cuts Becoming More Likely
After a stretch of disappointing progress toward the Fed’s 2.0% inflation target, the picture has brightened in the last couple of months (Display). It’s improved enough that we now expect the first rate cut in September rather than at the end of the year. In our view, that translates into two 25 basis-point cuts this year instead of one—and quarterly rate cuts through 2025.
That means rates are poised to come down a lot over the next couple of years, easing pressure on the US economy. That would be timely, because mounting evidence suggests that higher rates are weighing on economic growth. We’re not alarmed—a slowdown has been our central case for a while—but leaving rates high for too long could turn a slowdown into a recession.
We think the Fed should, and will, act soon enough to keep that from happening.
Cooling Shelter Prices—Good News for Inflation
The central bank increasingly has the data in hand to warrant pushing up the timetable for rate cuts, as the inflation picture has improved markedly with recent readings. After moving sideways early in the year, core inflation based on the Consumer Price Index (CPI) has regained its downward momentum over the last couple of months.
Inflation’s cooling late last year encouraged the market to price in as many as six rate cuts this year, but that was never our view. The main reason for our dissent: the details under the hood weren’t as encouraging as the top-line numbers suggested. Specifically, prices on goods normalized very quickly but services prices—that of shelter in particular—did not.
Things have changed recently, with significant progress made in bringing shelter inflation back down toward normal levels (Display). We think there’s more improvement in the pipeline: earlier moderation in housing prices is just now making its way into the CPI measure of shelter inflation. As that new data continues to feed through, we think overall core inflation will continue to fall.
Policy Easing Can Bolster Key Economic Sectors
With inflation sliding, we believe that the Fed will soon have the confidence it needs to start cutting rates. It’s a critical part of managing the economy, because higher rates have impaired a wide range of sectors.
Elevated mortgage rates have constrained housing activity, which has dented overall fixed investment. The housing market also has major knock-on effects on other parts of the economy. After all, buying a home is just the start; furniture and other accessories soon follow. With those purchases limited, overall household consumption has slowed this year, rising by 1.5% annualized in the first quarter.
That’s less than half the prevailing rate in late 2023 and well below the long-term average. With the consumer responsible for the majority of US economic growth, weaker consumption means lower gross domestic product (GDP). That’s exactly what we expect: after GDP rose by more than 3% in 2023, we currently forecast an increase of 1.5% in 2024, based on fourth-quarter comparisons.
Labor Market Pressures Ease—but Bear Watching
The US labor market is throttling back too—hiring is still strong, but less so. The unemployment rate is also up by roughly half a percentage point from its lows earlier this cycle (Display). A good share of that rise can be attributed to more available workers as migration flows have surged, but it still suggests that the labor market isn’t likely to push prices up in the coming months.
If anything, the labor market bears close watching—not because it could forestall an easing cycle but because it could accelerate one. If labor truly starts to weaken—with large layoffs, for example, we think our expectation of Fed cuts once a quarter will prove too conservative. With inflation on track to normalize, a weaker labor market would mean a more aggressive easing cycle.
To be clear, that’s not our base case. The unemployment rate remains very low by historical standards. Also, we think the modest increase recently is simply part of the process of bringing the labor market back into balance, rather than something that should cause alarm.
For now, we’re still comfortable saying that true economic weakness is unlikely and that a soft landing—an economic rebalancing without a recession—is most likely. The impending start of the Fed’s easing cycle gives us more confidence in that outlook. Cutting rates as inflation falls should keep the US economy on track, even if it’s a slower track than last year’s.
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