Chip Somodevilla / Staff
- The Fed so far has lowered inflation from historic levels without crushing growth.
- US GDP grew at 3.3% in the fourth quarter, the job market remains robust, and stocks are soaring.
- The Fed must now balance recession risks with a rebound in inflation.
At the start of 2023, Wall Street's recession calls were so loud they drowned out chatter of just about any other economic outcome.
There was no way the Federal Reserve could bring inflation down from multi-decade highs, the thinking went, without crushing economic growth. History appeared to be on the side of a downturn, as did longstanding indicators like the inverted yield curve.
Yet two months into 2024, Jerome Powell and his Fed colleagues seems to have nearly pulled off what many would have called a miracle not long ago.
While January CPI surprised to the upside at 3.1% year-over-year, and whispers of another potential rate hike have emerged in recent weeks, the likelihood of a recession has still diminished significantly. US GDP has remained above-trend the last two quarters — hitting 4.9% and 3.3% in the final two quarters of the year, respectively — and the labor market remains robust.
Consumers, too, look resilient, and despite the federal funds rate hovering above 5%, the stock market can't stop hitting record highs.
That said, Powell & Co. still has work to do to stamp out the last mile of inflation and deliver a vaunted Goldilocks scenario. Policymakers have to figure out how to ease interest rates without letting consumer prices reignite, while also preventing higher-for-longer borrowing costs tip the economy into a downturn.
"The longer the Fed stays in the danger zone of higher-for-longer, the risks of a crash or hard landing go up," James McCann, deputy chief economist with Abrdn, told Business Insider. "They are so close to pulling off this soft landing, and there's an understanding that they can't leave policy too tight for too long."
Between a rock and a hard place
The January Fed meeting minutes reinforced policymakers' careful approach for the months ahead. Some participants voiced concern that progress on inflation could falter if financial conditions ease prematurely, and others noted geopolitical shocks also pose a risk.
According to the minutes release, Fed officials will keep rates at current levels until they gain "greater confidence that inflation was moving sustainably towards 2%."
In effect, central bankers want to determine whether the hot CPI reading for January was a blip or the start of a troubling new trend.
"The minutes show the Fed is between a rock and a hard place, and that they're a little confused," Gene Goldman, chief investment officer for Cetera Investment Management, told Business Insider. "The hawks are saying there's a risk of moving too fast [with cuts], and the doves are saying there's significant disinflation already."
In Goldman's view, the latest January CPI report doesn't change his forecast for the central bank to start cutting rates this summer, either in May or June. Economic data are moving in the right direction, he said, and it'd be risky to change policy too close to the presidential election in September.
To be sure, as far as policy expectations, markets have only recently arrived on the same page as the Fed. In December, markets priced in roughly six cuts, even though the Fed's own outlook implied three.
On Thursday, CME's Fedwatch Tool showed markets give 95% odds of no move at the March meeting, up from 56% one month ago. For the May meeting, markets see a 25% chance of a rate cut, which has fallen by more than half since January.
In June, the odds of a 25 basis point cut hover at a coin flip, per CME data.
"I think the fact the Fed was burned by tightening policy a little late means they will likely to err on the side of maintaining a stricter monetary policy stance than conditions would otherwise dictate," Gregory Daco, EY's chief economist, said.
EY, for its part, expects 100 basis points of cuts in 2024, beginning in May.
Overly restrictive policy, Daco said, could lead to a slower growth backdrop, which would result in tighter financial conditions and a retrenching of private sector activity.
"The Fed doesn't want to be seen as having allowed inflation to reignite," he added.
Finishing the inflation battle
Last week, former Treasury Secretary Larry Summers said the Fed's next rate move could actually be up, rather than down. In comments that followed last week's inflation data, he said he sees a 15% chance for a rate hike.
"It's always a mistake to over-interpret one month's number," Summers told Bloomberg TV. "And that's especially true in January, where calculating seasonality is difficult. But I think we have to recognize the possibility of a mini-paradigm shift."
Cetera's Goldman anticipates neither a hike nor recession this year, though he maintained that the Fed must still stay mindful of the existing risks. Further hikes could break something in the economy, as pockets of pain have already emerged across commercial real estate and small businesses.
But the inflation battle is ultimately moving in the right direction, which should mean relief is on the way across the board, via easing policy.
"The economic data is still slowing down, credit care usage is surging, delinquencies are rising, inflation is rolling over," Goldman said. "You also have the fact that it takes 12 to 15 months for rate hikes to make an impact."
Abrdn's McCann, meanwhile, said the uncertain outlook doesn't change that the Fed will continue to be data-dependent, and the data point to mid-year rate cuts.
He said Powell is well aware of the policy mistakes from the 1970s, when the Fed eased rates too early and inflation bounced back and became entrenched, and those lessons will keep him from doing the same.
"They're conscious there could be lags, and it could be that the economy doesn't do as well with tight policy as it did last year," McCann said. "The Fed doesn't want to undo all the good work they've done, and needlessly push the economy into a recession."