In this, the latest analysis from Tiffany Wilding, PIMCO Economist, Tiffany offers analysis and research on economic themes that are likely to influence markets. In particular, she explains the Fed’s decision on when to cut interest rates is complicated by the growing gap between the core personal consumption expenditures (PCE) price index and the core consumer price index (CPI).
The US Federal Reserve has clearly conveyed it expects to cut interest rates in 2024 – and the question is when, how much, and how fast. Some observers suggest the first cut could come as soon as March.
Given the broader shift in Fed communications since mid-December (see our 19 December 2023 Macro Signposts, “Central Bank Cuts: Lessons From History” ), we agree March could very well be a “live meeting,” with the potential for a rate cut. We expect the Fed will give itself that optionality by removing the hiking bias in its forward guidance at its next meeting on 31 January.
Nevertheless, we find the balance of data and macroeconomic trends points to an initial rate cut closer to midyear. Our outlook reflects U.S. inflation data – including the widening gap between two important price indices – as well as continuing resilience in economic growth and the historical tendency for central banks to cut rates later than sooner.
Inflation measures paint different pictures
The Fed’s decision on when to cut interest rates is complicated by the growing gap, or “wedge,” between two key indices – the core personal consumption expenditures (PCE) price index and the core consumer price index (CPI).
The U.S. Bureau of Economic Analysis will release the PCE price index for December later this month. We project core PCE (which excludes volatile food and energy prices) to rise 0.2% month-over-month, with the quarter-over-quarter reading at 2.0% – the second consecutive quarter at 2.0%. We expect the year-over-year (y/y) measure to drop to 2.95% (from 3.16%) as higher numbers from late 2022 fall out of the calculation. This is notable: After peaking at 5.6% in mid-2022, y/y core PCE – the Fed’s preferred inflation measure – may be entering the “2-point-something” zone.
Recent trends suggest core PCE inflation will continue falling. We project the y/y February core PCE index (due at end-March) will be 2.7%. This data will be released after the Fed’s March meeting deliberations, but related data can help construct a close estimate.
Core PCE inflation has recently made much faster progress toward the Fed’s 2% target than the CPI, though sequentially both measures have recently been moving in the wrong direction. The wedge is growing, with CPI remaining at more elevated levels despite the faster PCE inflation progress – and this can confound policymaking. If December PCE data comes in where we expect, the wedge will have widened to 0.9 percentage points for y/y measures, and 1.2 percentage points on a 3-month annualized basis (with core CPI running at 3.9% y/y versus core PCE at 3.0% y/y (rounded up to the nearest tenth)). In other words, although a 2-point-something core PCE reading could give the Fed cover to cut rates, the fact that core CPI is running near 4% creates challenging optics.
If PCE and CPI both measure aggregate changes in price levels for U.S. goods and services, why do they differ, and why does the wedge between them widen and narrow over time? PCE and CPI measure inflation differently, and changes in the wedge tend to be driven by two things. One is that the indices assign different weights to various goods and services (e.g., shelter has a much higher weight in CPI, while medical services has a higher weight in PCE). The other is that because CPI is designed to capture inflation from “out-of-pocket” consumer expenses, it does not include non-market prices, including the healthcare services priced by the government and consumed by households that are included in PCE.
The faster decline in PCE inflation over the last two quarters has been largely driven by the second factor: declines in non-market services price inflation, and in particular declines in healthcare-related inflation. Looking ahead, inflation in these areas is likely to continue diverging. PCE measures not only healthcare paid by private insurance (which is captured by CPI’s out-of-pocket measure), but also government-administered insurance programs, including Medicaid and Medicare. PCE also includes nonprofit healthcare provider margins, which measure the extent to which nonprofit providers can pass on high input costs, including higher wages. This contrasts with CPI healthcare inflation, which captures medical procedure prices paid for out-of-pocket and by private insurance, as well as insurance retained earnings.
What does all of this mean? Healthcare inflation (including the consumption of nonprofit healthcare services) will likely look a lot better in PCE than in CPI in 2024, keeping the wedge relatively wide. The Medicare/Medicaid price adjustments for 2024 were similar to previous years, and generally have not kept up with actual wage inflation in the industry. The good news for the Fed is that healthcare wage inflation is now falling, reducing inflation in nonprofit healthcare providers serving households. However, because CPI will capture the higher prices paid by private insurers, plus higher retained earnings in the health insurance industry, CPI-reported healthcare inflation is poised to reaccelerate, while in PCE it should decline.
In short, non-market factors are driving the relative good news in core PCE, while core CPI remains elevated. These divergent trends could make the optics of cutting in March tricky.
Near-term growth momentum
The wonky methodological details of the price indices aren’t the only factors that could influence the March decision. Other factors that could prompt the Fed to hesitate to cut rates sooner include the U.S. economy’s persistent resilience in the face of more contractionary fiscal policy in the latter half of 2023 and slower credit growth. Meanwhile, easier financial conditions in the most rate-sensitive sectors, such as residential real estate investment, will likely support near-term growth momentum.
This matters because various econometric models created to decompose the post-pandemic inflationary episode suggest that most of the increase in inflation resulted from pandemic-related factors (fiscal stimulus, supply chain bottlenecks, etc.), and similarly, most of the recent good news has been related to these same factors fading (or even reversing, in the case of easing backlogs within the auto industry). However, underlying all of this is a still-tight labor market, with inflation likely to run around 2.5%–3% without restrictive monetary policy contributing to further labor market easing.
Signs of hesitation
Finally, historical precedent also provides insights in the behavioral aspects of central banking: Central bank officials usually tend to lag in easing. Typically, they would begin easing when their economies were already in recession. As we discussed in our Cyclical Outlook, “Navigating the Descent,” there have been a handful of instances when central banks eased absent a recession. However, fear of Arthur Burns’ legacy (he chaired the Fed amid rampant inflation in the 1970s) may well keep policymakers focused on managing inflation risks for a few months longer.
Official Fed communications since the December meeting have been more or less consistent with waiting somewhat longer. And by our count, Fed policymakers Williams, Mester, Logan, Bowman, and Bostic have also pushed back against a March cut to varying degrees. Even Goolsbee, who has been more dovish, suggested his rate-path projections were closer to the median, implying March might also be a little early. He also hinted that Fed officials still haven’t completely shifted back to a more balanced focus on both sides of the dual mandate: “If it continues to be clear that we are on (the) path to get back to that, then we also start paying more attention to the other side of the mandate,” Goolsbee said. Finally, a recent speech by Fed Governor Waller also emphasized the importance of a slow and “methodical” adjustment back to neutral when the Fed does begin this process.
Bottom line
Inflation has come down a long way from its 2022 highs, especially if you look at the PCE measure. However, with non-market prices driving the relative good news in PCE, while CPI is still running hotter, the inflation optics of a March rate cut may still be challenging. This, plus a surprisingly robust economy, and central bankers’ historical tendency to cut with a delay, suggests to us that while a March cut remains possible, waiting a bit longer may be the more realistic timing.
