The Federal Reserve is forecast to cut interest rates just once this year. The latest round of monthly data has some economists worried that the reduction will not come soon.
Retail sales data for May on Tuesday showed the pace of consumer spending is slowing compared with a year ago, easing concerns about the economy running too hot in the fight against inflation. In the labor market, while last month's job growth exceeded expectations, the unemployment rate hit 4%, its highest level since January 2022. Overall, Citi's economic surprise index, which measures the extent to which data came in better than forecasts, is hovering near its lowest level in more than a year.
Meanwhile, inflation data for May was more promising than expected. The headline consumer price index (CPI) rose at its slowest pace since July 2022. Combining that data with readings on wholesale prices in May, economists believe the Fed's preferred inflation gauge, the personal consumption expenditures (PCE) index, grew at its slowest pace of the year during May.
With inflation falling and the economy in recession, Renaissance Macro's Neil Dutta believes now is the time “for the Fed to get on with it” and start cutting interest rates soon. Dutta says this would help protect the Fed's other mandate besides price stability: maximum employment.
“The momentum behind core inflation will probably continue to soften from here,” Dutta told Yahoo Finance. “Then I think for the Fed, the trade-offs with the labor market are going to become a little bit more cumbersome.”
Dutta points out that any sign of weakness in the labour market has so far been interpreted as a sign of rebalancing, as the pandemic has caused imbalances in supply and demand.
Federal Reserve Chairman Jerome Powell has also acknowledged this.
“We are seeing a gradual cooling down and a move towards better balance.” [in the labor market]“We are monitoring carefully for signs of anything more than that, but we don’t really see anything like that,” Federal Reserve Chair Jerome Powell said after the central bank’s most recent policy meeting on June 12.
But Dutta and the Goldman Sachs economics team are concerned about where the data typically goes from here. The rate of job openings is now in line with pre-pandemic levels. If it falls further, a jump in the unemployment rate will typically be accompanied by a downward trend, Dutta said, referring to the Beveridge curve.
As the work of the Federal Reserve shows, moving the points on the Beveridge curve further to the right axis (as can be seen in the chart marked in red below) will reduce the likelihood of a soft landing and possibly a recession.
“I don't think the Fed wants to extend the slowdown in labor demand any further,” Dutta said.
“The Fed knows this. The risk at this point is not that the unemployment rate will drop unexpectedly. The most likely distribution of outcomes is that it will remain stable or that it will rise further,” he said.
To be clear, Dutta and other economists are more concerned about how the economic data is going to play out in the future than what it is today. Many are still not too concerned about current trends.
Matthew Luzzetti, Deutsche Bank's chief U.S. economist, told Yahoo Finance that “risks” remain in the labor market. But at this point, it looks like U.S. consumer spending power is not trending toward a decline but rather slowing toward a normal pace.
“While there are some pressures, particularly for certain segments of households, I would be surprised if you see a slowdown in the labor market and in the consumer that is enough to trigger a cut by September,” Luzzetti said.
From a stock perspective, investors have taken the current Fed outlook seriously. The S&P 500 (^GSPC) and Nasdaq Composite (^IXIC) are on track for consecutive record closes. Three equity strategists have raised their year-end outlook for the S&P 500 as tech companies continue to perform better than expected.
But one of those strategists, Citi US equity strategist Scott Cronert, highlighted that the “poor state” of the economy would remain a topic of interest to investors going forward, as corporate executives were “cautiously optimistic” about first quarter earnings.
“We'll be watching this very closely,” Cronert told Yahoo Finance. “I think, in general, what we'll see in the second quarter reporting period will be a little bit more evidence that the impact that the Fed's interest rate hikes have had so far is starting to have an impact on fundamental activity. So, we should be aware of that.”
Some worry that in sounding cautious on inflation, the Fed could inadvertently wait too late to act and hurt the economy. With excess savings dwindling and credit card liabilities rising, Allianz chief economic adviser Mohamed El-Erian told Yahoo Finance that small businesses and low-income families, already struggling amid higher rates, could be left out to dry.
El-Erian argued that if the Fed waits until the end of the year to cut, the balance of risks to it “is in favor of the fact that they will be too late and the economy will slow more than expected.”
Josh Shaffer is a reporter for Yahoo Finance. Follow him on X @_joshshaffer,
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