By Ryan Boyle

Parents of young children will recognize the danger of a one-word question: “Why?”  By persistently asking why, a child can frustrate and unravel the thinking of their caregivers.

We are re-learning the power of that simple question.  We had expected the Federal Reserve to start cutting rates in June.  But as more of our audiences asked why, we saw the case was not strong.  This week’s inflation reading seals the deal: we now expect the easing cycle to start in September.

The consumer price index (CPI) for March was above expectations, rising 0.4% for the month on both a headline and core basis.  The details were all too familiar: shelter inflation remains stubbornly elevated.  Core services excluding housing ticked upward, led by volatile categories like vehicle maintenance and insurance.  On a year over year basis, core service prices have been rising since October 2023; components of this category share a common dependency on labor.  New immigration has not yet relieved the limited supply of skilled workers, and their wage gains are passing through to prices.

While the Fed targets personal consumption expenditure (PCE) inflation rather than CPI, the two indices have moved in tandem in this cycle.  And while the target excludes the volatile categories of food and energy, higher gasoline prices will keep this matter top-of-mind for consumers.

Another factor arguing against reducing rates is the persistent strength of the American economy.  In 2019, the Fed cut rates by 75 basis points in anticipation of weakening growth.  We see no softening today, and no need for a similar proactive cut.  Employment and personal income are both exceptionally strong.  Sectors that were shocked by the rise in interest rates, like banking and homebuilding, have adjusted to the new rate regime.  Risk assets are rallying, credit spreads are narrow, and financial conditions are easy. 

The Fed has emphasized their data-dependent approach, but they do risk putting too much weight on recent readings.  The uncooperative start to 2024 follows a good disinflationary run in 2023.  The risk of a new reflationary cycle remains low, absent any further supply shocks.  A dovish policymaker could make a case for cuts in light of the long-run improvement.  On this basis, we do still expect to see easing later in the year.  However, the current Fed governors remain committed to their objective of taming inflation.  Further progress will be needed, more than can be seen between now and June.

The last mile of the inflation recovery always loomed to be the hardest.  Initial progress down from the peak was easy as stimulus programs ended and supply chains healed, but the remaining distance will require policy discipline.  If we ultimately achieve a soft landing, holding rates higher for even longer will be an important reason why.