We Need to Talk

He Said, She Said, He Said, and then He said Nothing

Fed unity was not exactly on display as the central bank tried to re-position itself last week.  Now, what's left is a divided Fed deciding whether to cut interest rates three times. At Powell’s March 20 press conference, he was confident the FOMC will see an imminent reversal in price increases and the FOMC will deliver three interest rate cuts in 2024. Investors were overjoyed, and the equity market rallied to record highs. The question remains whether the rest of the FOMC voters would rally to his side. We got our first answer a week ago Friday when the president of the Atlanta Fed said two days after the meeting that he favors  just one cut for this year.

On Wednesday, March 27, Fed Governor Waller also questioned the three-rate cut view, declaring he is not as convinced as Powell that we are on track toward 2% inflation. Waller believes U.S. economic resilience and strong labor demand allow  the Fed to hold off on rate cuts for now. He thinks it prudent to  keep rates at their currently restrictive level “perhaps for longer than previously thought” to put more pressure on inflation. He questioned whether the productivity gains that helped push inflation down last year are sustainable and noted that the number of FOMC voters expecting two or fewer cuts had increased at the March meeting.

Two days before  Waller’s speech, Fed Governor Lisa Cook said that inflation can return to 2% if the Fed is careful. Markets hoped for a resolution when Powell spoke on Friday, March 29, but he was noncommittal. Powell repeated his base case, which remains a continued decline to 2% inflation, and in the less likely case that “inflation progress slows,” the FOMC will keep rates unchanged. Powell was pleased that the February Personal Consumption Expenditure (PCE) data aligned  with their expectations. He ignored the higher inflationary aspects of the report. However, as a nod to Fed Governor Waller, he added that the economy is strong, so the central bank doesn’t need to be in a hurry to cut rates. The lines have been drawn: it will take Powell saying , “the base case is we are not making progress on bringing inflation down” to derail the equity bull run.

PCE Distillery

The February PCE inflation data was on expectations, showing inflation on a slight downward glide path over the past six months, which impressed Powell. Yet, the report's details support FOMC members seeking  fewer than three rate cuts. First, January’s substantial numbers were revised even higher, and while February’s year-over-year rate fell to 2.8%, January originally was listed at a 2.8% rate. Hence, the drop in inflation is due to January being bumped higher. It is a stretch to consider that a meaningful drop. Secondly, Governor Waller and the other FOMC voters are focused on annualized core measures over a three-month and six-month period to determine inflation’s direction. Using those metrics, he concluded that progress in bringing down inflation has stalled.

Looking at those shorter-term inflation trends, the 3-month annualized PCE inflation rate fell but is still high at 3.2%, and the six-month rate rose from 2.6% to 2.9%. Therefore, the data will not convince Waller or the growing number of FOMC voters who expect two or fewer rate cuts this year that Powell’s disinflation view has arrived.

The Dallas Fed provides a distillation of the more than 170 price series that go into the PCE inflation calculation, and they found that over 40% of those products and services have risen by more than 5%. A quarter of those high-inflation items have risen by more than 10%. This elevated level of inflation is concerning, and Atlanta Fed President Raphael Bostic cited the Dallas Fed study when he said that 20% is a level he finds consistent with the Fed’s 2% inflation objective. Given his yardstick, the number of excessive inflation items needs to drop in half before he joins Powell in believing the Fed will cut rates three times this year. That is a tall order. The market will hope March inflation data clarifies the path for short-term interest rates either with the April 10 CPI report or PCE on April 26, before the May 1 FOMC meeting.

Sweet Caroline?

Good times never seemed so good, at least to investors. While the stock market hit new highs, the Conference Board’s March Consumer Confidence Index revealed that consumers are concerned about their financial condition, elevated services inflation, and higher interest rates. First, the good news: The Conference Board Present Situation Index for March rose slightly, driven by an increase in those who believe “jobs are plentiful” relative to those who said “jobs are hard to get.” That spread, called the Labor Differential, points to another good nonfarm payroll report this Friday. Now, for the not-so-good news: Consumer optimism fell among those who earned between $50,000 and $100,000. Among all consumers, pessimism grew over their family’s financial situation in March. Additionally, the Expectations Index, measuring consumers’ six-month outlook, fell to the lowest reading in five months and sits at levels normally associated with recessions.

Digging deeper, only 25% of those polled perceive services prices will fall over the next two quarters, which is bad news for any FOMC voter who hopes for a fall in inflation expectations. Expectations for future business conditions, income expectations, and, notably, labor market conditions all fell this month. While the Labor Differential shows improvement currently, those polled by the Conference Board anticipate that fewer jobs will be available over the next six months. Over half of all consumers believe interest rates will rise into March 2025. Given this increasing pessimism, it should be no surprise that buying plans for big-ticket interest-sensitive items such as cars, homes, and appliances dropped in March. This deteriorating outlook fits with the PCE report that reflected higher spending but lower income in February, portraying an average consumer who is becoming tapped out. 

What to Look for This Week

1. The nonfarm payroll number is released this Friday, April 5. Fed Governor Christopher Waller is looking for a reversal lower in the 3.9% unemployment rate because the recent increase was driven by an exceptional rise in the number of 16-24-year-olds counted as unemployed. That is one element in the report that will get our attention. As mentioned earlier, the Conference Board’s Labor Differential is making many economists more optimistic about this report, so we will see if that is borne out.

2. On Monday, April 1, the ISM Purchasing Managers Index will be released. It is forecast to hit its highest level in 17 months, although it is still expected to be below 50 once again. The manufacturing index is always an important report but deserves special attention after Chicago’s PMI abruptly dropped to its third lowest level since the 2020 pandemic last Thursday.

3. Fed Quadrophenia: a search for clarity on Tuesday as four FOMC voters speak during market hours. Governor Bowman wants fewer rate cuts and three moderates: San Francisco Fed President Daly, Cleveland Fed President Mester, and New York Fed President Williams. There are 12 FOMC voters in total, so this is a critical contingent. We will be looking for signs of patience on whether to cut rates or for alignment with Chairman Powell’s view of three rate cuts over the six remaining FOMC meetings in 2024.