US - Fed to tread more carefully with rate cuts

National accounts data due later this week are likely to show that GDP slowed further in Q1 from the very strong second half of 2023. We and consensus expect growth of around 2.5% annualised, down from 3.4% in Q4 and 4.9% in Q3 last year, but still somewhat above the trend rate of growth. Incoming data suggests growth continues to be driven by solid consumption, although the bottoming out in global trade and industry (see this month’s Global View) is also helping, with manufacturing output having also grown modestly over the quarter. That growth has not slowed more sharply is surprising considering the impact of high rates on things such as subdued bank lending and rising credit card delinquencies (see our March Global Monthly). This resilience likely continues to reflect the aggregate strength of household and business balance sheets, which seems to be offsetting the pockets of weakness in interest rate-sensitive parts of the economy. As a result of the ongoing resilience, we have further raised our 2024 GDP growth forecast to 2.5%, up four tenths from our previous 2.1% forecast. While we still expect the economy to continue slowing, we think the trough will be even shallower than previously thought, with growth expected to bottom out a touch below trend at c1.5% over Q2-Q3, before falling interest rates lift growth again in late 2024 and into 2025.

Despite the strength in growth, we continue to think the recent hot CPI inflation readings are giving off more noise than signal about the outlook. As the past year has shown, monthly inflation outturns have been volatile, and most of the strength we see is being driven by aftershocks from the 2021-22 inflation surge. For instance, the jump in housing rents has yet to fully pass through, and prior rises in car parts prices, as well as the resumption in traveling and higher accident rates associated, has led to an unusual jump in car insurance premiums. Pipeline pressures for inflation, including the latest data for new housing rent leases, as well as wage growth, continue to suggest a benign inflation outlook. As such, we think we are overdue some downside surprises on the inflation front over the coming months.

Still, the Fed will need to be more convinced before it starts to cut rates, after being burned by the inflation is transitory mantra in 2021. We think the Fed will need to see 2-3 benign inflation readings to be confident that it is back on track to meet its 2% inflation target. Assuming we see more benign readings for inflation over the coming months, we think the Fed will want to get some easing ‘in the bag’, considering the lags with which monetary policy works. This therefore favours a first cut in July (previously June). However, given the volatility we have seen in inflation, we also think it is reasonable that the Fed proceeds more carefully with rate cuts initially. While the precise timing of any pause will depend highly on the dataflow at that time, we judge that September would be a reasonable point to hold policy and take stock of developments before proceeding further. By November, inflation should be more durably back at the Fed’s 2% target, which should give the Committee the confidence to cut at consecutive meetings until a more neutral level of interest rates (around 3%) is reached in late 2025.

Could the presidential election scupper rate cut plans? We think not. We happen to think the data will support a September rate pause, but the November FOMC meeting will take place just after the election. As such, any move is unlikely to be seen as politically motivated, regardless of the outcome. See our Fed Watch for more.