The Fed’s Inflation Outlook Is a Little Too Pessimistic

Ivanna Hampton: And then there was one. The Federal Reserve is projecting they’ll trim interest rates only once in 2024 instead of three times. The announcement followed the same-day release of the May Consumer Price Index report that signaled inflation is easing. But is the Fed’s forecast for interest-rate cuts too cautious? Morningstar Research Services’ senior US economist Preston Caldwell is here to share his insights.

Thanks for joining me, Preston.

Preston Caldwell: Thanks for having me, Ivanna.

Good News From the Fed’s New Inflation Report

Hampton: Let’s start with the new inflation report. Why was it considered good news? And where is inflation still proving sticky?

Caldwell: After a rough beginning to 2024, it was really a breath of fresh air. So, core CPI was 0.16% month over month. That means that later this month when the core PCE data comes out—the PCE is really the final word as far as inflation goes—that probably core PCE inflation will be 0.1% month over month. So, we don’t want to overreact to one month’s data, but even zooming out for broader context, it looks like core PCE over the last three months will be averaging about 2.8% annualized. That’s a pretty improved state compared to where we were in the three months ending in March of this year when the core PCE inflation rate had risen to 4.4% annualized. That spooked a lot of people. And after the second half of 2023 when inflation was back to 2% over that period in terms of core PCE, when it shot up in the first quarter, markets were very worried about that, and the Fed was also worried. And people started to think that this road to normal for inflation could last a lot longer than we had hoped. The last several months of data are very positive. It looks like that benign environment that we saw in the second half of 2023 could be returning.

Now, as far as where we stand in terms of the composition of inflation, core PCE is likely to be at about 2.5% or 2.6% year over year as of May. And if we subtract housing, if we were to just look at core PCE excluding housing, that would actually be at 2.1% year over year. You could say that excluding housing, we have returned to normal for inflation. And there are a few other pockets to be sure. But overall, housing is the one main component that’s single-handedly still propping up inflation. And the leading-edge data still strongly indicates that housing inflation is likely to normalize soon. So, that should encourage us on the inflation front.

Will the Fed Cut Interest Rates in 2024?

Hampton: The Fed is predicting they’ll cut interest rates just once. Can you talk about why you consider that outlook too cautious and what are your expectations?

Caldwell: The Fed put out these updated projections today. The last time they had updated their projections was March. Now, what’s important to remember is that—and [Fed Chair Jerome] Powell talked about this today in his press conference—the committee members who make these projections have the ability to update their forecast after the CPI release that was this morning, but most generally don’t. So, to some extent, this is looking in the rearview mirror because this may not be totally reflecting the data with the CPI that was released this morning.

So, in any case, the Fed is projecting that core PCE inflation in the fourth quarter of this year will stand at 2.8% year over year. I think that’s a little too pessimistic. I think based on how inflation will track over the rest of this year, that will be at 2.4%, not 2.8% year over year, core PCE inflation at the end of this year. That’s much more optimistic on inflation. And so, I think if inflation comes in below the Fed’s more pessimistic estimate, then they will end up cutting two or three times rather than the one cut that they’re baking in. And it looks like markets agree with that. I think markets appear to be a little bit closer to our optimism on inflation right now because you saw markets move sharply in a way that anticipates looser monetary policy when the CPI was released this morning, but they didn’t really move that much. And right now, they’re really not reflecting the Fed’s projection of one cut. The median projection in the fed fund’s futures market is that we’ll have two cuts by the end of this year, which is about in line with what our view is. So, it really just hinges on inflation, and the Fed will be data-dependent and react to however the inflation data comes in.

How Investors Can Interpret the Fed Lifting Its Long-Run Interest Rate

Hampton: And meanwhile, the Fed lifted its long-run interest rate that some see as a stand-in for the so-called neutral rate. How should we interpret this move?

Caldwell: The Fed upped its projection of the neutral federal-funds rate to 2.8% from 2.6% back in March. For years, this estimate had been anchored at 2.5%. So, it’s starting to tick up. Now just to back up here, the neutral rate of interest, or neutral federal-funds rate in this particular instance, is a theoretical concept that marks the interest rate that allows the economy to grow right in line with its potential. That means that the Fed is able to achieve both parts of its dual mandate—full employment and 2% in inflation—should that state of the economy prevail. That basically means it’s a good guide for what the long-run interest rate is likely to be, or the interest rate is likely to be in the long run.

Now, I think the fact that the economy has been so strong over the past few years even as interest rates have been high in reality has led some people to think that the neutral rate might be higher than the 2.5% that they previously expected. So, we’re starting to see that gradually be reflected in Fed members’ expectations. But still, though, they haven’t changed their year-end 2026 federal-funds rate expectation at all over this period. That’s still at 3.1%, which is unchanged from the last meeting. So, it’s unclear how this affects the ultimate trajectory of the federal-funds rate. And Powell himself acknowledged in the press conference today that there’s still a lot of debate about this, about how much the neutral rate has shifted, because the neutral rate reflects slow-moving forces in the economy like demographics and long-run productivity growth. And it’s hard to imagine how much has changed since before the pandemic. And we’re going to need a lot of data and a lot of debate before we start to revise our views on this topic.

I still think that the neutral rate is probably quite low as it was before the pandemic, and that’s a big reason why I think the federal-funds rate will ultimately subside much lower than ultimately the markets expect. I think the federal-funds rate will drift down to a target range of 1.75% to 2.00% by year-end 2026. And that’s my long-run expectation.

Hampton: Well, Preston, thank you for sharing your insights today.

Caldwell: Thanks for having me, Ivanna.