CIO Notebook: Inflation Data Lifts Stocks But Fed Remains Unconvinced

June 13, 2024

In our view, economic expectations, particularly around U.S. growth, continue to point to both higher inflation and higher interest rates through the next several years

With earnings season and a stronger-than-anticipated U.S. payrolls report in the rearview mirror, investors were keyed in on both the release of U.S. CPI and the Federal Reserve (Fed) as the markets opened on Wednesday. The mood was initially upbeat as May’s U.S. headline CPI was reported as flat month-over-month and up +3.3% year-over-year, versus expectations of +0.1% and +3.4%, respectively. Even more encouraging was the deceleration in core CPI, which was up +0.2% (rounded from +0.16%) month-over-month and up +3.4% on a year-over-year basis—the slowest year-over-year pace since 2021.

Driving the better print for headline CPI was a sharp -3.6% month-over-month drop in gasoline prices. While gas prices are a more volatile component of inflation measures, it is also an example of a cost borne by a majority of consumers and, as such, typically has an impact on confidence. Food prices were also higher, with food generally up +0.1%, and food away from home up +0.4%. Shelter continues to be the primary driver of headline and core CPI increases on a month-over-month basis; it was up +0.4% once again in May. Medical care, used cars and education were also higher in the month, while communication, new cars and apparel were lower. Perhaps most importantly, in our view, services prices such as housing and energy were flat month-over-month, indicating that some of the longer lags may finally be resolving.

On the heels of the CPI release, the Fed announced its statement on interest rates. As expected, the Fed maintained the federal funds target rate at 5.25% to 5.50%. The only major change in statement was the acknowledgment of “modest” further progress in moving closer to the Fed’s inflation target. The Fed also released an updated dot plot that reflected a shift in terms of rate-cut expectations from the March release. Specifically, the dot plot now represents only one cut in the federal funds rate for the year versus the two cuts telegraphed in last quarter’s plot. Admittedly, eight of the voting members of the Federal Open Market Committee (FOMC) expect two interest rate cuts this year, but with this quarter’s release, seven members expect only one rate cut and four expect rates to remain stable through the end of the year. In terms of long-term expectations, by the end of 2025, the dot plot reflects a federal funds rate of 4.1% with the level eventually falling only to 2.8% on a longer-term basis, up from 2.6% in March.

Driving this shift in the dot plot is likely the increase in core PCE expectations for the end of the year; the Fed is now projecting core PCE to stand at 2.8% going into 2025 versus 2.6% in the March projection. While the increase seems somewhat counterintuitive given the inflation progress over the last two months, Fed Chair Jerome Powell noted both some challenging year-over-year comparisons for the second half of the year and a dose of conservatism in setting that bogey. Forecasts for GDP growth in 2024 and 2025 were steady at 2.1% and 2.0%, respectively, and the unemployment rate is expected to close the year at 4.0%, but rise to 4.2% by the end of 2025, up from 4.1%. Chair Powell was careful to point out that the labor market is not yet showing signs of cracking, but is instead returning to a more normal state, specifically citing immigration and prime working age individuals coming back into the workforce, coupled with fewer openings and quits as factors in creating that better balance.

While perhaps not the dovish tone equity investors were hoping for following the morning’s release, we believe Chair Powell’s adoption of a neutral yet cautious tone likely fills the foundation for solid equity market performance through the end of the quarter. He said sources of risks remain for the Fed at this inflection point, and stated that he and the other members of the FOMC are not naïve to the risk that remaining restrictive for too long can disrupt the labor market and pressure an already modestly weaker consumer. In our view, economic expectations, particularly around U.S. growth, continue to point to both higher inflation and higher interest rates through the next several years. The admission from the Fed of a higher long-term neutral rate versus pre-pandemic levels may have greater bearing on the decisions for both companies and consumers than the specific path by which we get there.


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