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When Will the Fed Declare Victory on Inflation?

30 January 2024

The U.S. economic expansion shows no sign of abating. With strong consumer spending, a solid labour market, and inflation at the doorstep of price stability, the outlook is solid. The Federal Reserve Bank of Atlanta is calling for Q1 growth of 3%, following growth of 3.3% in the fourth quarter. It is looking more likely that the Fed has engineered a soft landing, with the economy posting solid growth, low unemployment, and progress toward achieving price stability.

US CPI rose 3.4% annually to close out 2023. While higher than the previous month, it represents a significant decrease from the inflation rate of 6.5% observed in December 2022. The core inflation rate, which excludes the volatile categories of food and energy, was 3.9%. 

Shelter costs remain elevated, but it’s important to note that the CPI’s measurement of shelter prices has a lag, primarily due to the timing of data collection and the delay resulting from the method of rent collection. For the month ending in December, CPI indicates a 6.2% increase in shelter costs.

There will be no linear path to the 2% inflation target. The journey will be shaped by persistent service inflation and sticky housing costs. In December, the Federal Reserve’s preferred inflation measure, the Personal Consumption Expenditures (PCE) index, increased by 2.6%. Excluding food and energy, the core PCE increased by 2.9% annually. The core PCE inflation is currently at its lowest point since March 2021.

As of now, things appear to be heading in the right direction.

On the goods side, inflationary pressure from rising prices for everyday items like food, beverages, and clothing are being offset by the slower pace or decline in the prices for gasoline, recreational goods, furniture, and other durables. At the same time, shelter costs look to be on a downward trend, which should play a significant role bringing U.S. inflation closer to the 2% target.

Looking at wages, Americans’ personal incomes continued to grow in December, rising 0.3% from the prior month. However, savings declined during the holiday shopping month, coming in at 3.7% of disposable income, a decrease of 0.4% from November. On an annual basis, income has increased by 4.8%, wages and salaries are up by 6.8%, and disposable income has risen by 6.9%.

Furthermore, consumer sentiment has increased to the highest level since July 2021, according to the University of Michigan. Over the past two months, consumer sentiment has surged by 29%, marking the most significant increase since 1991.

The lingering question is when the Federal Reserve will feel confident enough to declare victory over inflation and begin to lower interest rates. Our call is that an early easing is not in the cards. Despite inflation moderating in line with the Fed’s expectations, economic growth has been stronger than expected and the stock market is up sharply. This reduces the need for early easing, and, from the Fed’s viewpoint, raises the risk of rekindling inflation.

A crucial factor in this decision-making process is productivity. If productivity continues to show gains, it should help keep the Fed on track to lower rates. This week’s productivity report is expected to show a 2.6% increase in output per hour in the fourth quarter in the private non-farm business sector, with unit labor costs of around 2.1%. This aligns well with the Fed’s 2% inflation goal.

In their communication this week, the Fed is likely to acknowledge the strong pace of economic growth while expressing cautious optimism that inflation will move back toward the 2% target. Concerns about persistent inflation, particularly in the context of a tight labor market, will make the Fed cautious about prematurely declaring victory.


Independent Opinion

The views and opinions expressed in this publication are solely and independently those of the author and do not necessarily reflect the views and opinions of any person or organization in any way affiliated with the author including, without limitation, any current or past employers of the author. While reasonable effort was taken to ensure the information and analysis in this publication is accurate, it has been prepared solely for general informational purposes. Any opinions, projections, or forward-looking statements expressed herein are solely those of the author. There are no warranties or representations being provided with respect to the accuracy and completeness of the content in this publication. Nothing in this publication should be construed as providing professional advice including investment advice on the matters discussed. The author does not assume any liability arising from any form of reliance on this publication. Readers are cautioned to always seek independent professional advice from a qualified professional before making any investment decisions.

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