Fed Declares Mission Accomplished

The Federal Reserve declared victory today, projecting a soft landing as its base case in the years ahead, with more cuts in short-term rates, and with inflation gradually getting back to its 2.0% goal without a recession. Unfortunately, we think the Fed is declaring mission accomplished too early.

The Fed didn’t change short-term interest rates today, nor did it alter the pace of Quantitative Tightening, but it made major changes to its projections for short-term interest rates. Not one policymaker on the Federal Open Market Committee thinks the short-term interest rate target will be higher a year from now than it is today, which is 5.375%. And while the median forecast from policymakers in September was one rate cut of 25 basis points in 2024, now the median projection is 75 bps. In turn, the median policymaker projects another 100 bps in rate cuts in 2025 and then another 75 bps in 2026.

True, inflation is trending down. The Consumer Price Index is up 3.1% from a year ago versus a 7.1% in the year ending in November 2022. But much of the improvement is due to energy, which is down 5.4% in the past twelve months. The Core CPI is still up a worrisome 4.0% from a year ago compared to 6.0% in November 2022. In other words, the Fed is likely to have more trouble getting broad measures of inflation, like the CPI, back down to its goal than it has bringing it down in the past year or so.

Moreover, the Fed should be focused on not cutting rates too aggressively and prematurely, which could re-ignite the inflation problem like the Fed did on multiple occasions under Chairman Arthur Burns in the 1970s. The economy is still growing for now, but we think it falls into recession in 2024 and that real GDP growth significantly lags the 1.4% predicted by the FOMC. Given that the Fed has now signaled 75 bps in rate cuts even in an environment of moderate growth, if we are right about economic growth it will be very difficult for the Fed to resist generating higher inflation in 2025 and beyond.

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