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Economic and Market Commentary

Persistent Inflation Pressures Could Delay Fed Action

The March U.S. inflation report and other macro data will likely prompt a change in the Federal Reserve’s trajectory in 2024.

The U.S. consumer price index (CPI) rose 0.38% in March, slightly hotter than the consensus forecast and continuing an unsettling trend. Taking out more volatile food and energy prices, the net 3-month annualized core CPI inflation rate is now above 4.5%. More concerning, one of the Federal Reserve’s preferred aggregations within that measure – core services ex shelter – accelerated to 8% on a net 3-month annualized basis. Markets were quick to respond to the stronger inflation data, signaling a much lower likelihood of a Fed rate cut in June or July than previously priced.

To put it mildly, the March data complicate the timing of the Fed’s policy rate cuts. The elevated and accelerating inflation data present a strong case for the central bank to delay an initial rate cut past midyear, even though midyear has seemed to be its clear preference based on recent communications. We expect the Fed will need to once again raise its core personal consumption expenditures (PCE) inflation forecast, and this time lower the total number of rate cuts it anticipates making in 2024 (down from three 25-basis-point cuts per its latest projections in March). Absent surprisingly weak inflation or labor market reports between now and June, we agree with the market signals that the Fed will likely delay.

U.S. CPI: key details and outlook

Goods inflation was subdued as used car prices fell more than expected in March, while core services ex shelter inflation accelerated, driven by a jump in auto insurance prices. Looking ahead, the issue for the Fed is that core goods deflation has likely troughed, while services ex shelter inflation should remain sticky absent a further easing in the labor market – something that appears less likely following the strong March employment report.

Given the strength of the March CPI report, we have nudged our U.S. inflation forecast slightly higher, and now are projecting the year-over-year rate of core CPI to end 2024 at 3.5% or a bit above, versus our previous expectation for a 3%–3.5% range.

Macro and monetary implications

The March CPI report, strong March labor market data, and Q1 real GDP indicators (which suggest notable growth in domestic demand) all point to a U.S. economy that is still running hot, despite some help from improved supply-side production.

Turning to other data of particular interest to the Fed, we believe the March core PCE inflation report will look a little cooler than CPI because it measures auto insurance differently and places less weight on shelter components. However, core PCE inflation still could be running around 3% for Q2 (seasonally adjusted and annualized), by our estimates. This is down slightly from our estimate of 3.4% inflation in Q1, but still above the Fed’s target of 2% PCE – or even the “two-point-something” that would appear tolerable to the central bank provided inflation is moving generally in the right direction.

Collectively, the March CPI and employment reports bolster our view (shared in our recent Cyclical Outlook, “Diverging Markets, Diversified Portfolios”) that the Fed will likely ease monetary policy at a more gradual pace than its counterparts in other developed market economies. Indeed, there’s a non-negligible possibility that the Fed doesn’t cut in 2024 at all – and market prices suggest investors see this possibility too.

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