Fed Reduces 2024 Rate Cut Projections Despite Softer April Inflation

Fed Reduces 2024 Rate Cut Projections Despite Softer April Inflation 

U.S. inflation eased in April according to the Consumer Price Index (CPI) data released on Wednesday. Despite this softer inflation data, Federal Reserve policymakers reduced their expectations for interest rate cuts this year. The new dot plot published on Wednesday showed a median projection of just one rate cut before the end of 2024, compared to three cuts projected in the March dot plot.

Why the change?

Is inflation no longer the main driver of interest rate policy?

Actually, inflation remains a critical factor for Fed policy and the markets.

The seeming contradiction between softer inflation and more hawkish rate projections is due to two factors: timing and confidence.

Regarding timing, the reduction in rate cut projections is a delayed reaction to the inflation concerns from the first quarter. In March, policymakers had only seen the high inflation data from January and February, which they dismissed as temporary or "bumps in the road," as Fed Chair Jay Powell put it. However, the March inflation data released on April 10, showing a third consecutive high reading, made policymakers reconsider the possibility of persistent inflation. Wednesday was their first chance since then to update their rate expectations for the year.

As for confidence, the first quarter's inflation scare made policymakers cautious. Even with relatively benign inflation data in April and May, they did not revert to projecting three rate cuts this year. The first quarter's hot inflation prints delayed the expected start date for rate cuts. Without a crisis, this start date remains delayed despite subsequent softer inflation prints. The Fed needs to see consistent, low inflation before regaining confidence that inflation is sustainably heading toward the 2% target. Therefore, the window for rate cuts this year is narrower than it was in March, leading policymakers to reduce their expected rate cuts for 2024.

Considering these aspects of timing and confidence, there is no contradiction between May's softer inflation data and Wednesday's more hawkish guidance from the Fed. Inflation remains the main driver of rate decisions, not politics or government finances, and will likely continue to be so until the end of Powell's term in 2026. However, if Powell were replaced by a political appointee, this could change.

What's next for inflation?

With money supply contracting, supply chain pressures easing, mixed growth data, and falling gasoline prices, the base case is for inflation to continue moderating. If this happens, the Fed may justify one or two rate cuts before the end of the year. However, significant risks to this outlook remain. The wealth effect from rising asset prices could boost demand, and housing rent, a significant component of U.S. inflation indexes, might not decrease as quickly as expected. Powell acknowledged that the lag between new rents and their impact on inflation data may be longer than previously thought.

Valuations remain a concern for both bonds and equities, with equity earnings yields low compared to real yields on bonds and even lower compared to real yields on bills. Nevertheless, with moderating inflation, the possibility of rate cuts, excitement over AI, and significant share buybacks (thanks to companies like Apple), investors are currently ignoring relative valuations and driving up the prices of both bonds and equities.