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Economic Monitor – Weekly Commentary
by Eugenio Alemán

CPI inflation and Federal Reserve rates decision: Back to the drawing board?

April 12, 2024

Before we start discussing the Consumer Price Index (CPI) again, we want to remind readers that CPI inflation is not what Federal Reserve (Fed) officials use to determine monetary policy. It is true that markets put a lot of emphasis on this measure, but we would like to caution giving too much importance to it. Please take a look at past Weekly Economics where we discuss the differences between the CPI and the PCE price indices, and the reasons why the latter is the one the Fed uses to conduct monetary policy.

With this caveat, the release of the March Consumer Price Index (CPI) was another reminder that the last stretch of the fight against inflation is not going to be easy. The fundamental reason for this is that U.S. economic growth has remained strong and job growth has kept real disposable personal income supportive of consumption and thus of continuous upward pressure on prices.

For the Fed, the biggest question is “what to do in this environment?” If it waits and keeps interest rates at 5.5%, there is a risk that economic growth continues to remain robust and inflation will probably not slow down much more, giving credence to those who have been arguing that inflation will remain above the Fed’s 2% target forever. If this is the case, and Fed officials believe that strong economic growth is the reason inflation is not coming down enough to reach the 2% target, then it has to start thinking of the possibility of increasing interest rates further. However, we believe that the Fed already knows that the fight to bring down inflation to the 2% target will be a long one and that is the reason it has the PCE price index achieving the 2% inflation target rate in 2026, not today or next year. Thus, it can sit tight and not increase interest rates and wait for the rate of inflation to, slowly, go down to 2%, which seems to be the current base case.

If this is the case, then the question is, when is the Fed prepared to start decreasing interest rates. Before this last CPI release, we had already indicated that the March dot plot release was in ‘flux,’ with Fed officials showing no conviction on the start date for lowering interest rates. So, markets have been warned and have started to act upon this new stance. And this higher than expected CPI print has the potential to cement the belief that it may have to wait longer before starting to cut interest rates. In that vein, markets have already moved to expecting fewer than three rate cuts this year while concluding that June is probably not going to be the start date for rate cuts.

Although we are still not convinced and would like to wait for more data to make any changes to our rate cut expectations, we understand that the first quarter of the year CPI reports have not been good for Fed officials and for the potential start date for a rate cut.

Our hesitation today has to do with three fundamental issues. First, as we said at the beginning of this weekly, the CPI is not the inflation index used by the Fed to conduct monetary policy as it tends to overstate the rate of inflation in the economy. Second, the Fed doesn’t need to see inflation at 2% to start cutting rates, it just needs to be convinced that inflation will continue to come down. This is still possible because we expect the economy to slow considerably during the second and third quarters of the year, so there is still a possibility that the Fed may cut rates to prevent further weakness. And third, the strength in the CPI during the first quarter of the year may be related to changing seasonal factors and Fed officials would not want to make a policy decision that has the potential to be a mistake. This is because if there are revisions to seasonal factors for 2024, these adjustments may show weaker inflation during the first quarter of the year, suggesting that the decision to not alter Fed policy was correct.

Thus, we would like to wait for the release of the PCE price index at the end of this month and then wait for more information on how inflation, and the U.S. economy, is evolving, before making a change to our rate projection. We understand that markets, and many economists, have already changed their forecast for the first rate hike to September but, as we said before, we would like to wait for more information on economic activity to make a more informed decision.

Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those Raymond James and are subject to change without notice the information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the U.S. Bureau of Labor Studies. Currencies investing are generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

The National Federation of Independent Business (NFIB) Small Business Optimism Index is a composite of ten seasonally adjusted components. It provides a indication of the health of small businesses in the U.S., which account of roughly 50% of the nation's private workforce.

The producer price index is a price index that measures the average changes in prices received by domestic producers for their output. Its importance is being undermined by the steady decline in manufactured goods as a share of spending.

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