The November CPI report showed that the overall disinflationary trend is continuing, but it’s likely not going to support the idea that rate cuts are going to be imminent in the first half of 2024. While the headline rate ticked down another tenth of a point, the core rate remains sticky at 4%. Some higher base effects will begin rolling off of the 12-month calculation now and that will help in bringing that rate lower, but core inflation is still running over 3% on a 3-month annualized basis. There’s just not much evidence yet that the core rate is going to come down close to the Fed’s 2% target for at least, probably, another 6 months. All of those investors banking on the fact that the Fed is going to start cutting in Q2 and will cut several times in 2024 might want to start rethinking their expectations.
You’d have to go all the way back to the early 1990s to find the last time where the Fed Funds rate started dropping when inflation was still high. Let’s look back at past rate cutting cycles. When the Fed started cutting in 2019, the core inflation rate was 2.1%. In 2007, again it was at 2.1%. In 2000, it was 2.5%. You’d have to go all the way back to 1991 when core inflation was around 5% to find a time when the Fed Funds rate was dropping. There’s almost no precedent for the start of a significant rate cutting cycle starting when inflation is at its current level. Investors clearly have a more modest view on inflation (the New York Fed issued a survey that showed that inflation expectations have fallen to early 2021 levels) and that’s likely helping fuel If investor optimism gets called out by Powell this week, the markets could quickly turn south.
Given that the market is pricing in roughly an 80% chance of at least 4 quarter-point rate cuts in 2024, investors are clearly bullish that monetary conditions will soon work in the favor of risk asset prices. The Fed, however, is unlikely to offer a similar tone this week. Powell has consistently repeated the threat of additional rate hikes as a means of trying to prevent the markets from doing the loosening for them. For all of his faults, the Fed has actually followed through pretty consistently on its core messaging. Throughout 2022, the markets tried to talk themselves into the idea that a Fed pivot was near only for Powell to throw cold water on the idea pretty quickly. Powell said to expect several more rate hikes last year even though the market didn’t want to buy it, but the Fed delivered several more rate hikes. Whether this proves to be the correct path in trying to pull off the soft landing remains to be seen, but the Fed has largely followed through on its messaging over the past two years. If Powell comes out this week and says that rate cuts are still several quarters away, it would be wise not to dismiss it. The further that market expectations get away from the Fed’s messaging, the greater the risk of a significant market reaction to get them back in line.
Keep reading with a 7-day free trial
Subscribe to The Lead-Lag Report to keep reading this post and get 7 days of free access to the full post archives.