Wall Street and the American consumer are eagerly awaiting rate cuts, especially those looking to buy or sell a home. However, consumers are still spending, and earnings remain robust as our economy continues to outperform forecasts. This has had an interesting effect on inflation. While U.S. inflation has declined from over 9% in the summer of 2022 to nearly 3% in the second half of 2023, it has moved back up to 3.5% and appears to be stuck in a range between 3% to 3.5%. The Federal Reserve (Fed) is still trying to get inflation back down to 2% because elevated inflation impacts every single consumer from the grocery store to restaurants, gas pumps, flights, hotels, and so on. The Fed has said time and time again that the ‘last mile’ is the hardest. They want to declare victory on inflation and begin cutting rates. The concern is cutting too early, which could cause a second wave of inflation, just like what occurred in the 1970s. Ironically, inflation rates of nearly 12% are about to celebrate their 50th anniversary in the 3rd quarter later this year. No one wants to see a repeat of the decade-long period now coined The Great Inflation. This is why Fed Chairman Jerome Powell has come out numerous times recently and said that the Fed is not in any hurry to start cutting rates. The Fed will get inflation back down to its 2% target, but it will take time.
The lessons of The Great Inflation offer a warning that this fight is not over yet and that cutting too early can have dire and long-term consequences. In 1971, then Fed Chairman Arthur Burns, cut rates from 5.5% to 3.5% even though inflation was still between 3% and 4%. GDP growth accelerated from 3% to 5%, but inflation also surged to 12%, peaking a few years later at over 14%. Inflation became entrenched. It took many years for inflation to get back down to the 2% range. In the early 1980s, Paul Volcker, then Fed Chairman, had to hike rates to a level we had never seen before (nearly 20%) to break the back of inflation. Powell is VERY aware of what happened in the '70s and early '80s, which is why he has said for quite some time, as recently as March, “Reducing policy restraint too soon or too much could result in a reversal of progress we have seen in inflation and ultimately require even tighter policy to get inflation back to 2%.” As a result, market expectations have been adjusting very quickly. The Fed is adamant about trying to avoid the mistake of cutting rates too early, which led to The Great Inflation.
In January, Wall Street was expecting six to seven rate cuts by the end of the year, something we thought was unrealistic based on the current economic environment. Despite the sharp interest rate increases of the past two years, the economy continues to be resilient, the consumer is still spending, and the labor market is staying robust. As a result, inflation is still above target. Reactively, Wall Street has continued to lower its expectations, now at one to three cuts. Inflation is sticky, and we are not seeing the economic slowdown that many have anticipated for more than a year. As the economy stays resilient, so does inflation, but neither is out of control (see Kyron’s column).
We maintain our cautiously optimistic outlook, assuming the economy stays resilient and the jobs market remains robust. We continue to closely monitor earnings announcements, which start this week, and pay close attention to what is said regarding consumer spending. If the jobs market remains strong, it should allow for the Fed to achieve the soft landing that has thus far been so elusive to attain. In the meantime, as the old adage goes, good things come to those who wait.