S&P Global Ratings now believes that conditions for a monetary policy easing by the Federal Reserve won't be in place before autumn. The Fed won't cut rates until it sees several consecutive readings of slowing month-over-month core inflation, in our view, and so its first rate cut will likely come in December--several months later than we had previously forecast.

When we stated our views back in March about the trajectory of rate cuts--75 basis points (bps) of cuts this year, starting in July--we said that the balance of risks was tilted toward a delayed first cut, a slower pace of easing, and higher year-end rates for 2024 and 2025. The data released since then--both new data and revisions to previous data--suggests that those risks have materialized.

Some of that data points to the underlying momentum of the U.S. economy, which remained robust in the first quarter. At the same time, the Fed's preferred inflation gauge--the personal consumption expenditures (PCE) price index--pointed to a reversal of the disinflationary momentum of last year. Inflation readings from the last three months likely overstate the remaining excess inflation, but they still lower our confidence in a Fed rate cut happening before autumn--especially given the upside risk to our inflation outlook due to strong consumer demand.

Recently, the Fed has also reinforced the idea that its deliberations are data-dependent, and it has said that inflation needs to cooperate going forward if it is going to cut rates. While it held its policy rate unchanged at 5.25%-5.50% on May 1, Chair Jerome Powell said that rate cuts will come into scope when the Fed has enough confidence that inflation is on its way to 2% sustainably, barring an unexpected weakening in the labor market. Just as the Federal Open Market Committee (FOMC) was cautious about the encouraging inflation data in the second half of 2023, it will not overreact to the latest readings. In the past, Powell has reiterated his previous guidance that policymakers don't need to see year-over-year inflation at 2%; rather, they just need to see "several months" of month-over-month inflation at an annualized rate near 2% to be confident that inflation will get to the 2% target.

We also don't think the Fed will feel the need to start hiking rates again. Monthly inflation of 0.3% (in February and March) is too high to justify cuts, but it's also not enough to warrant restarting the tightening cycle. The risk of there being no rate cuts in 2024 has risen, but we remain in the camp that believes that disinflation will resume in coming quarters.

We continue to believe the most likely path is the one where real GDP growth slows as the year progresses to below potential (with 1.8% year-over-year growth in the fourth quarter), and where annualized monthly inflation is at 2% consistently enough for the Fed to ease its policy rate by year-end. Because underlying economic activity has been slightly hotter than we expected, a delay in the Fed's easing will likely cool GDP growth to the degree that our base-case forecast for GDP growth published in March will remain intact (see "Economic Outlook U.S. Q2 2024: Heading For An Encore," published March 26, 2024). We continue to believe that the long and variable lag of restrictive monetary policy, together with elevated inflation, will gradually erode still-solid domestic demand over the course of 2024. We expect the Fed to pick up the pace of easing next year, cutting rates to 4.00%-4.25% by the end of 2025.

Our recalibrated projections are by no means a lock. The Fed's reaction function could change--there's nothing stopping the Fed from keeping rates where they are for longer if it decides, even for optics, that annual inflation must get under the 2.5% threshold. Besides, there's no shortage of upside risks to our inflation outlook--from lingering excess demand to supply-related shocks that could stymie disinflation and ultimately spur another recalibration of rate cut expectations. On the other hand, the Fed's employment objectives could start to come into more focus now that inflation is under 3%, thus making the central bank more sensitive to labor market weakening.

Market prices also suggest a delayed start to rate cuts. They currently point to a first cut in November.

Economic Momentum Persists

The U.S. economy remains healthy despite weak headline GDP growth in the first quarter.  The growth rate in the first quarter (1.6%) may have been less than half the growth rate in fourth-quarter 2023 (3.4%), but the headline first-quarter growth figure masked the underlying strength of domestic demand. Excluding the volatile figures for net exports and inventories, final sales to domestic purchasers grew 2.8%, with private demand expanding 3.1%--a truer indication of the trajectory of economic growth at the start of this year.

Consumer spending once again was the main driver of real GDP growth, and the shift from goods spending to services spending is seemingly in full swing.  Spending on big-ticket goods that need be financed, notably vehicles, has been dropping, while consumers are catching up on medical care. Solid annual gains in both employment and real wages, a positive wealth effect, and the use of savings and consumer credit contributed to robust annualized consumer spending growth of 2.5% in the first quarter. And with real spending up 0.5% in both February and March, consumer spending momentum will likely persist in the second quarter.

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We expect the underlying economic momentum to weaken back to trend amid high interest rates.  The consumer economy right now may not look like it's burdened by high rates, but it would be a mistake to think that strains from high rates won't creep into the economy with time. Income growth has significantly lagged spending growth since mid-2023, and so households have been increasingly reliant on credit and savings. Excess savings are likely depleted for all but the highest-income households, and delinquency rates on credit cards and auto loans have risen beyond pre-pandemic levels. We think consumers will rein in their spending more and more as time goes on.

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The softer-than-expected April reading from the S&P Global Market Intelligence Purchasing Managers' Index (PMI) pointed to continued weakness in business sentiment despite solid consumer outlays. The manufacturing PMI fell almost two points, to 50 (no change level), while the services flash PMI fell eight points, to 50.9. In addition, sentiment has been more negative among small businesses.

At the same time, as the prospects of a Fed easing in the short term have diminished, the feedback effects from that--including tighter financial conditions from a stronger U.S. dollar, higher benchmark Treasury yields and mortgage rates, and lower stock market values--have likely been headwinds to growth, all else being equal, so far in the second quarter.

To be sure, it's likely that overall GDP growth will pick up next quarter, partly reflecting the payback of trade and inventory components in subsequent quarters, as well as a higher starting level of private consumption. Average quarterly growth for the first half will likely settle at an annualized rate of about 2.2%, not far off our March forecast of 2%. And we continue to expect that real GDP growth, on a four-quarter-change basis, will land in the fourth quarter near the 1.8% long-run trend rate, lower than the 3.1% rate for 2023. (All of this translates to an average annual growth rate of 2.5% in 2024.)

A Disinflation Hiccup Means It Will Take Time To Get To The 2% Target

Inflation didn't show the kind of progress in the first quarter that the Fed would need to start cutting rates in the summer.  Quarter-over-quarter core PCE inflation accelerated to an annualized rate of 3.7% following two consecutive quarters of 2% inflation. Still, the annual rate of core PCE inflation edged lower in February and March, to 2.8% from 3.2% in the fourth quarter; base effects masked the quarter-over-quarter acceleration of inflation in the first quarter. In March, goods inflation fell less than expected, and core services inflation rose for a third consecutive month.

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The path to sustainable 2% inflation was never going to be a smooth one to begin with.  The reacceleration of PCE inflation is likely a temporary deviation from its underlying trend, just as the deceleration to 2% in the third and fourth quarters of last year was also a temporary deviation from trend. We think the "on trend" level splits the difference--in the 2.5%-3% range--and that can be seen in two common, preferred measures of underlying inflation. A Werning-type analysis of embedded inflation using a combination of 12-month price catch-up and 12-month forward expectations shows underlying inflation near 2.5%. At the same time, a nonlinear hybrid Phillips curve--first put forward last year by researchers at the Federal Reserve Bank of San Francisco--points to underlying core inflation at about 3%, with the potential for a modest increase in labor market slack (our baseline later this year) coinciding with a sizable decline in inflation (still on the relatively steep part of the curve).

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Despite upside surprises in inflation, the broader disinflationary trend hasn't changed.  First, we expect the supply-side potential of the economy to grow somewhat faster this year than the long-run potential estimates--just as it did last year--because of the elevated level of immigration, which has boosted labor force growth. Strong demand growth won't necessarily worsen the economy's supply-demand balance--and thus, inflation--if supply is keeping up.

Second, the labor market continues to rebalance, with churn rates that have normalized to pre-pandemic levels and with a trajectory of wage growth that continues to be favorable. We think wage growth will trend toward 3.5% by next year--a pace that is consistent with the 2% inflation target if we assume 1.5% productivity growth (matching the 30-year average) and stable profit margins.

Third, household surveys, professional surveys, and bond market break-evens suggest that inflation expectations remain anchored and consistent with 2% inflation. While short-term break-even compensation in the bond market and households' one-year inflation expectations have both increased, we think they're more a function of volatile oil prices and gas prices, respectively.

Fourth, goods prices should still decline (though the declines will be more modest going forward). That will allow for more of an adjustment to relative prices without services prices needing to rise much.

Last, special factors (like inflation in financial services and auto insurance) had an unusually large impact on first-quarter inflation, and shelter inflation hasn't slowed as sharply as we had expected. Going forward, the contribution from special factors should unwind, and forward-looking indicators of shelter inflation still point to further moderation this year. Indeed, there should be disinflation in shelter prices over the course of the year amid the lagged impact of price measures on the administrative data.

Inflation in the "other services" category is generally tethered to wage growth, which, by all measures, has been slowing. As for the health care component of PCE, noneconomic factors are also at play; inflation in medical prices (including drug pricing) in the PCE index will remain cool because of effective government price controls.

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We don't think we can take the last three months of core PCE data, extrapolate it forward, and treat the result as the most realistic scenario for year-over-year core PCE inflation.  We believe that sequential monthly inflation close to 2% will return. The Federal Reserve Bank of Cleveland's inflation "nowcast" (which estimates inflation in real time) showed April core PCE inflation at 0.2% as of April 29, which is already a step toward a 2% annualized rate.

Still, even with several months of sequential 0.2% inflation readings, the annual inflation rate will likely stall in the 2.6%-2.8% range this summer and rise during the second half to 2.9% because of unfavorable base effects on year-over-year calculations. We anticipate renewed declines in the annual inflation rate in early 2025, with a convergence to 2% late in the year.

The Federal Reserve Will Have To Stay Patient

The data-dependent Fed can't discount the higher inflation prints of the last three months as a statistical aberration, especially in the context of still strong GDP growth and employment gains.  Fed officials in their public remarks have increasingly acknowledged the upside risks to their own inflation forecasts published in mid-March (which were likely prepared with data up to January). This means there's a materially higher chance that there will be less than 75 basis points of easing in 2024 (the median assumption consistent with the Fed's macro forecasts). The next summary of economic projections from the FOMC participants will be published in June.

Prices in the futures market now imply barely a 50% chance of a rate cut before September, and for good reason. With the acceleration in inflation over the past three months, inflation will need to come in soft in every one of the inflation reports coming up for the Fed to feel confident that inflation remains on a sustainable path back to 2%.

This is especially true given what the optics of easing would be like if year-over-year inflation were still above 2.5%. It may be asking too much for inflation to fall exactly in line with what inflation optimists and some investors hope for, especially given the uncertainty surrounding the durability of consumer resilience, the pace of housing disinflation, and supply chain risks on goods prices.

The Fed announced on May 1 that it will begin to slow the pace of balance sheet run-off in June, as we had anticipated. It will slow the pace at which it reduces its securities holdings by reducing the monthly redemption cap on Treasury securities (to $25 billion from $60 billion). It will maintain the monthly redemption cap on agency debt and agency mortgage-backed securities at $35 billion, and it will reinvest any principal payments in excess of this cap into Treasury securities.

For now, balance sheet policy and interest rate policy are on two independent tracks. The thinking behind starting to let quantitative easing taper off is that it would enable individual banks to tackle reserve shortages before they affect the entire system and, thus, enable the Fed to potentially get to a smaller balance sheet position (although it would take longer to get there).