CPI inflation and Federal Reserve rates decision: Back to the drawing board?

Chief Economist Eugenio J. Alemán discusses current economic conditions.

Before we start discussing the Consumer Price Index (CPI) again, we want to remind readers that CPI inflation is not what Federal Reserve (Fed) officials use to determine monetary policy. It is true that markets put a lot of emphasis on this measure, but we would like to caution giving too much importance to it. Please take a look at past Weekly Economics where we discuss the differences between the CPI and the PCE price indices, and the reasons why the latter is the one the Fed uses to conduct monetary policy.

With this caveat, the release of the March Consumer Price Index (CPI) was another reminder that the last stretch of the fight against inflation is not going to be easy. The fundamental reason for this is that U.S. economic growth has remained strong and job growth has kept real disposable personal income supportive of consumption and thus of continuous upward pressure on prices.

For the Fed, the biggest question is “what to do in this environment?” If it waits and keeps interest rates at 5.5%, there is a risk that economic growth continues to remain robust and inflation will probably not slow down much more, giving credence to those who have been arguing that inflation will remain above the Fed’s 2% target forever. If this is the case, and Fed officials believe that strong economic growth is the reason inflation is not coming down enough to reach the 2% target, then it has to start thinking of the possibility of increasing interest rates further. However, we believe that the Fed already knows that the fight to bring down inflation to the 2% target will be a long one and that is the reason it has the PCE price index achieving the 2% inflation target rate in 2026, not today or next year. Thus, it can sit tight and not increase interest rates and wait for the rate of inflation to, slowly, go down to 2%, which seems to be the current base case.

If this is the case, then the question is, when is the Fed prepared to start decreasing interest rates. Before this last CPI release, we had already indicated that the March dot plot release was in ‘flux,’ with Fed officials showing no conviction on the start date for lowering interest rates. So, markets have been warned and have started to act upon this new stance. And this higher than expected CPI print has the potential to cement the belief that it may have to wait longer before starting to cut interest rates. In that vein, markets have already moved to expecting fewer than three rate cuts this year while concluding that June is probably not going to be the start date for rate cuts.

Although we are still not convinced and would like to wait for more data to make any changes to our rate cut expectations, we understand that the first quarter of the year CPI reports have not been good for Fed officials and for the potential start date for a rate cut.

Our hesitation today has to do with three fundamental issues. First, as we said at the beginning of this weekly, the CPI is not the inflation index used by the Fed to conduct monetary policy as it tends to overstate the rate of inflation in the economy. Second, the Fed doesn’t need to see inflation at 2% to start cutting rates, it just needs to be convinced that inflation will continue to come down. This is still possible because we expect the economy to slow considerably during the second and third quarters of the year, so there is still a possibility that the Fed may cut rates to prevent further weakness. And third, the strength in the CPI during the first quarter of the year may be related to changing seasonal factors and Fed officials would not want to make a policy decision that has the potential to be a mistake. This is because if there are revisions to seasonal factors for 2024, these adjustments may show weaker inflation during the first quarter of the year, suggesting that the decision to not alter Fed policy was correct.

Thus, we would like to wait for the release of the PCE price index at the end of this month and then wait for more information on how inflation, and the U.S. economy, is evolving, before making a change to our rate projection. We understand that markets, and many economists, have already changed their forecast for the first rate hike to September but, as we said before, we would like to wait for more information on economic activity to make a more informed decision.

Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those of Raymond James and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur. Last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Statistics. Currencies investing is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample.

Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.

The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100.

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.

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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren't part of this index.

The Conference Board Leading Economic Index: Intended to forecast future economic activity, it is calculated from the values of ten key variables.

The Conference Board Coincident Economic Index: An index published by the Conference Board that provides a broad-based measurement of current economic conditions.

The Conference Board lagging Economic Index: an index published monthly by the Conference Board, used to confirm and assess the direction of the economy's movements over recent months.

The U.S. Dollar Index is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies. The Index goes up when the U.S. dollar gains "strength" when compared to other currencies.

The FHFA House Price Index (FHFA HPI®) is a comprehensive collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities that extend back to the mid-1970s.

Import Price Index: The import price index measure price changes in goods or services purchased from abroad by U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).

ISM New Orders Index: ISM New Order Index shows the number of new orders from customers of manufacturing firms reported by survey respondents compared to the previous month. ISM Employment Index: The ISM Manufacturing Employment Index is a component of the Manufacturing Purchasing Managers Index and reflects employment changes from industrial companies.

ISM Inventories Index: The ISM manufacturing index is a composite index that gives equal weighting to new orders, production, employment, supplier deliveries, and inventories.

ISM Production Index: The ISM manufacturing index or PMI measures the change in production levels across the U.S. economy from month to month.

ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers' Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.

Consumer Price Index (CPI) A consumer price index is a price index, the price of a weighted average market basket of consumer goods and services purchased by households. Changes in measured CPI track changes in prices over time.

Producer Price Index: A producer price index (PPI) is a price index that measures the average changes in prices received by domestic producers for their output.

Industrial production: Industrial production is a measure of output of the industrial sector of the economy. The industrial sector includes manufacturing, mining, and utilities. Although these sectors contribute only a small portion of gross domestic product, they are highly sensitive to interest rates and consumer demand.

The NAHB/Wells Fargo Housing Opportunity Index (HOI) for a given area is defined as the share of homes sold in that area that would have been affordable to a family earning the local median income, based on standard mortgage underwriting criteria.

The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index measures the change in the value of the U.S. residential housing market by tracking the purchase prices of single-family homes.

The S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index seeks to measures the value of residential real estate in 20 major U.S. metropolitan.

Source: FactSet, data as of 7/7/2023