As 2023 drew to a close, stock markets surged, and economists rejoiced amid growing talk of an impending soft landing, fueled by speculation of imminent interest-rate cuts. Despite Wall Street projections suggesting the Federal Reserve might ease policy by as much as six times, central bankers themselves forecasted no more than three cuts.
However, the optimism surrounding the "immaculate disinflation" narrative faced a setback as 2024 commenced, with several economic reports presenting a more nuanced picture:
- January CPI exceeded expectations, climbing 3.1% year-over-year compared to the anticipated 2.9%.
- January PPI surpassed projections, rising by 0.3% instead of the expected 0.1%.
- Nonfarm payrolls for January increased by 353,000, surpassing the anticipated 187,000.
- US GDP growth for the fourth quarter stood at 3.3%, surpassing the estimated 2.0%.
These factors, coupled with a resilient housing market, strengthened the case for the Federal Reserve to maintain higher interest rates for a prolonged period. Former Treasury Secretary Larry Summers added to this viewpoint by suggesting a "meaningful" chance that the Fed's next move could be an upward adjustment, assigning a 15% probability to this outcome.
Market sentiments have shifted accordingly, with traders eliminating expectations for a March cut, and data from Bloomberg indicating reduced expectations for moves in May and June. CME's FedWatch Tool now places the odds of a quarter-point cut in March at 6.5%, down significantly from almost 50% a month earlier. In May, markets project a 64% chance of no adjustment, up from 15% in the previous month.
While experts maintain that rate hikes this year are unlikely, the resurgence of discussions around this possibility is noteworthy. Concerns about potential economic repercussions and the difficulty in predicting the last phase of inflation, especially in the face of stickier-than-expected prices, contribute to the ongoing policy conversation.
The "January effect," a common phenomenon of price fluctuations at the beginning of the year, may explain the recent inflation surprise. Of particular concern is the owners' equivalent rent (OER) component, a substantial part of the Consumer Price Index (CPI). Goldman Sachs analysts noted a persistent OER-rent gap, highlighting potential challenges for core Personal Consumption Expenditures (PCE) to return to target levels.
Market participants seem to be accepting a higher-for-longer environment, in line with the Federal Reserve's recent messaging. The summary of economic projections in December initially suggested three rate cuts in 2024, but markets had anticipated a more aggressive approach. Recently, both the Fed and markets appear to be converging on expectations, acknowledging the need for a potentially more restrictive stance, as expressed by Summers. While rate hikes are not entirely dismissed, many still anticipate the Fed to ease policy later in the year, erring on the side of caution regarding inflation expectations.
