AMSCI Newsletter January 2024

It appears likely that the Federal Reserve not only is done raising interest rates, but it may start to cut them soon.

The federal funds rate was effectively zero for two years following the start of the Covid-19 pandemic, but in March 2022, the Fed began aggressively raising rates to try to control inflation, bringing them to the current range of 5.25 to 5.5 percent. The central bank has declined to increase rates further during its past three meetings, and it recently gave indications that it is preparing to reverse course.

The minutes of the Fed’s Dec. 12-13 meeting recorded that “participants viewed the policy rate as likely at or near its peak for this tightening cycle, though they noted that the actual policy path will depend on how the economy evolves.”

“Participants pointed to the decline in inflation seen during 2023, noting the recent shift down in six-month inflation readings in particular, and to growing signs of demand and supply coming into better balance in product and labor markets as informing that view,” the minutes stated. “Several participants remarked that the Committee’s past policy actions were having their intended effect of helping to slow the growth of aggregate demand and cool labor market conditions. … In their submitted projections, almost all participants indicated that, reflecting the improvements in their inflation outlooks, their baseline projections implied that a lower target range for the federal funds rate would be appropriate by the end of 2024.”

Although the next several sentences in the minutes hedged on that forecast – “Participants also noted, however, that their outlooks were associated with an unusually elevated degree of uncertainty and that it was possible that the economy could evolve in a manner that would make further increases in the target range appropriate” – the Federal Reserve’s economic projections predict a 0.75 percentage point reduction over the course of this year. Private sector analysts, meanwhile, are tending to predict double that amount of rate reduction.

Fed Chairman Jerome Powell said after the December meeting that, “We’re aware of the risk that we would hang on [to high rates] too long. We know that that’s a risk, and we’re very focused on not making that mistake.”

Powell also noted that rates could be cut before inflation is brought all the way back down to the central bank’s target of 2 percent.

“The reason you wouldn’t wait to get to 2 percent to cut rates is that policy would be too late,” he said. “You’d want to be reducing restriction on the economy well before 2 percent … so you don’t overshoot. If we think of restrictive policy as weighing on economic activity, it takes a while for policy to get into the economy, affect economic activity and affect inflation.”

Year-over-year inflation has been between 3 and 3.7 percent since June. In June 2022, it was at 9.1 percent. Even with higher interest rates in place to cool the economy, the labor market has continued to be strong, adding a higher-than-expected 216,000 jobs in December as “employment continued to trend up in government, health care, social assistance, and construction,” according to the Bureau of Labor Statistics. The unemployment rate is now 3.7 percent. It has been below 4 percent since January 2022, a streak unmatched in more than half a century.

While consumer confidence has been lagging recently, it surged in December with The Conference Board’s Consumer Confidence Index increasing nearly 10 percent from the previous month.

“December’s increase in consumer confidence reflected more positive ratings of current business conditions and job availability, as well as less pessimistic views of business, labor market and personal income prospects over the next six months,” the board’s chief economist said, noting that “December’s write-in responses revealed the top issue affecting consumers remains rising prices in general, while politics, interest rates and global conflicts all saw downticks as top concerns.”

Similarly, the University of Michigan Surveys of Consumers Index of Consumer Sentiment improved by nearly 14 percent from November to December, gains that the surveys’ director attributed to “substantial improvements in how consumers view the trajectory of inflation.”

Confidence in the manufacturing sector, however, remains weak. The Institute for Supply Management’s Purchasing Managers Index increased slightly from November to December, but the index remains so low as to indicate contraction in the sector and looming recession in the overall economy.

“Demand remains soft, and production execution is stable compared to November, as panelists’ companies continue to manage outputs, material inputs and labor costs,” the chair of the institute’s Manufacturing Business Survey Committee said. “Suppliers continue to have capacity. Eighty-four percent of manufacturing gross domestic product contracted in December, up from 65 percent in November.”

Housing starts increased nearly 15 percent from October to November and were more than 9 percent higher than the November 2022 total, according to the Census Bureau and the Department of Housing and Urban Development. Existing home sales in November inched up by less than a percentage point after five months of declines, the National Association of Realtors reported.

“The latest weakness in existing home sales still reflects the buyer bidding process in most of October when mortgage rates were at a two-decade high before the actual closings in November,” the association’s chief economist said. “A marked turn can be expected as mortgage rates have plunged in recent weeks.”

The Dow Jones Industrial Average closed on Jan. 10 at 37,695.73, nearly unchanged from where it ended 2023 but up more than 16 percent from late October. The S&P 500 Index has followed a similar trajectory and ended Jan. 10 at 4,783.45. The dollar on Jan. 10 was trading at 0.91 euros, 0.78 pounds, 145.53 yen and 7.16 yuan. On Jan. 15, the presidential campaign season officially begins with the Iowa caucuses. Republicans almost certainly will spend much of the year attributing higher prices and worker and consumer dissatisfaction to Bidenomics, while the president likely points to the country’s job growth and slowdown in inflation. And a government entity that tries to stay out of politics – the Federal Reserve – will make choices that will have a significant impact on the outcome of this political battle. Americans, as they say, vote with their pocketbooks, and, notwithstanding countless predictions, the result of what is expected to be another close election may come down to what the economic data say in eight or nine months.