US - Further pain needed to bring inflation back to target
Bad news on the inflation front in the US likely means rates stay higher for longer.
Following months of improvement, pipeline inflationary pressures are building once again
With the recent financial market turmoil easing somewhat, this makes it more likely that the Fed will raise rates a bit further – and keep rates high for longer – to be sure that inflation falls back to 2%
Tighter financial conditions have led us to downgrade our growth forecasts
The news on the inflation front has – for the most part – not been good over the past month. Aside from upside surprises to inflation itself, indicators for a number of pipeline pressures worsened, following months of sustained improvement. On the goods side, wholesale used car prices have rebounded sharply, meaning goods disinflation is likely to come to an end in the March CPI report. Bad news was also evident in new housing lease data, with rents also rising again (albeit modestly so far). Finally, the labour market continues to be more resilient than we expected at this point in the cycle, and although nominal wage growth remains well behaved, falling productivity is pushing unit labour cost growth higher – to 6.3% yoy in Q4, which was a sharp upward revision from the 4.5% in the preliminary estimate. It was not all bad news: producer price inflation unexpectedly declined in February, while falling global energy prices – driven by recession fears – are also still supportive of the disinflationary trend. Indeed, we still expect annual inflation to continue declining over the coming months. However, the recent resurgence in certain goods, rents and labour costs does raise the risk that the landing zone could be higher than the Fed’s 2% target.
Against this backdrop, the near-term growth outlook is looking more positive than we previously thought, but the medium-term growth outlook has darkened. For Q1, the Atlanta Fed’s GDPNow tracker stands at 3.2% annualised as of 24 March, driven by a sharp rebound in consumption in January, as well as an unexpected recovery in home sales and homebuilding. On consumption, we are sceptical that the strength will survive revisions (strong initial reads on consumption in Q4 were later revised down significantly), while a pickup in the savings rate suggests consumers are reaching a limit in how they can accommodate high inflation by using excess savings. There remains significant excess savings sitting on household balance sheets, but much of this is skewed to higher income groups, leaving lower income groups with little choice but to cut back on consumption in response to high prices. And the headwinds are only likely to get worse: even if the current tightness in financial conditions eases, the Fed is likely to continue tightening policy, as it actually needs to generate some economic weakness (and a rise in unemployment) in order to be sure that it will bring inflation back to its 2% target. Taking all of this together, while we have raised our Q1 GDP forecast, we have lowered our forecasts for subsequent quarters; this leaves our growth forecast at 0.7% for 2023, while for 2024, we lower our forecast to 1.6% from 2.0% previously.
One of the main drivers for our growth forecast downgrade is that we now expect a higher peak in the fed funds rate, and a later start in rate cuts. This assumes, importantly, that financial conditions ease again, and that there will be no sustained turmoil in financial markets that triggers a significant pullback in credit growth (see this month’s Global View). We now expect one more 25bp hike, leaving the fed funds rate at 5.00-5.25% by May, with rate cuts to start in December – one quarter later than our previous September expectation. See our for more.