Revising our 2024 inflation outlook: Moving back to a 2% target

The recent easing in inflation, a clear downward trend in rents and what we think is a budding productivity boom have led us to revise our inflation forecast for the year.

We now expect that the Federal Reserve’s preferred measure of inflation—the personal consumption expenditures price index—will reach the central bank’s target of 2% by midyear, which will lead the Fed to reduce its policy rate.

While we continue to forecast that the Fed’s rate cuts will begin in June, we would strongly advocate a May start date, in part to ease tight lending conditions for businesses. We still expect that the Fed will reduce the policy rate four times this year, by 25 basis points each.

But there is a chance that, because of robust growth in the labor market and economy, the Fed will adopt a slower pace of rate cuts even as inflation moves back toward the 2% target.

We are now confident that the cost of rents, which has been a notable sticking point in the Fed’s effort to tame inflation, will push the consumer price index below our original forecast of 2.5% by the end of the year.

Improvements in pricing data and the inflation outlook should underscore the Fed’s policy review for the year with respect to the overall target. Our sense is that our original case—for the target to be reset between 2.5% and 3%—is now moot.

We now think that the Fed may opt to reset the target between 2% and 2.5%, which would align policy with the reality of pricing dynamics in the post-pandemic era, a significant increase in geopolitical tensions and the move toward industrial policy among the major trading nations.

What we expect

With short-term inflation having moved near, and even below, the Fed’s 2% target over the past six months, we find it critical to reassess our inflation forecast and its implications for the Federal Reserve's rate path. Among our new conclusions:

• PCE is easing: The Fed's key inflation metric—the personal consumption expenditures price index—is likely to remain consistently at or slightly below 2% for the rest of the year and longer in our base case.
• CPI is falling: The longer-term headline year-over-year inflation will reach 2% by midyear, while core PCE inflation will settle around 2.5% also by midyear, slightly above the long-term target.
• Disinflation has taken hold: The new forecasts for both the overall and the core indexes point to faster disinflation than previously predicted, not only by our estimates but also by most market participants and even the Fed.
• Shelter will lead the way: The main driver of the declines will most likely come from the shelter component, shaving off roughly 0.5 of a percentage point from inflation on an annualized basis. Housing inflation should return to pre-pandemic levels or below this summer, given the recent leading indicators.
• Rate cuts in the summer: The declines should provide the Fed with a sufficiently long period of positive data to begin cutting rates in the summer, with June as our base case. We do not expect more than a 100-basis-point cut this year, given the timing of the first cut and a robust job market that should maintain a certain amount of pressure on some of the core service components.

The job is not done

Fed officials, based on their recent remarks, are in no hurry to cut rates as they ascertain risks to restoring price stability and work to maintain maximum sustainable employment and stable financial conditions.

Many Fed governors want to see more positive data, implying that six months' worth of such data is not sufficient to begin reducing what we think is a restrictive policy rate.

That means the job is not done yet for the most powerful central bank in the world, even though most indicators are pointing toward a soft landing for the economy this year.

We think the mantra of "the risk of doing too little outweighs the risk of doing too much," which the Fed has consistently communicated, remains the key factor in its playbook, especially when the economy has shown no sign of an imminent recession.

But the more relevant question right now is: How much good data is enough? In our estimate, the Fed is likely leaning toward needing to see another six months of good data to ascertain that inflation is truly under control.

That time period, however, does not mean that Fed officials will wait until inflation—using the PCE index on a year-ago basis—has returned to 2%. In fact, we think, and the Fed has said, that it will not wait that long.

The chart below shows the difference between 2019 and 2023 for the percentage-point contribution of the main inflation components to overall monthly increases on a six-month moving average.

Gasoline, other energy goods and motor vehicles were the most important factors contributing to the recent rapid disinflation. 

Given consumers' continued strength, a rebound in goods and energy inflation remains a risk. Housing accounted for more than the discrepancy between today's inflation rate and the pre-pandemic rate over the past six months.

On top of that, food prices stayed elevated compared to 2019 levels, while core services like recreation, transportation, financial and insurance remain a concern.

These services are more sensitive to wage inflation, which has been trending upward. More than anything, the Fed is carefully watching these components and the overall market to reassess its rate-cut calculation.

Shelter disinflation

A likely drop in housing component inflation should work in the Fed's favor, offsetting any rebound in other categories. By examining the Cleveland Federal Reserve's new tenant rent index, which provides a better real-time indicator for housing and rental prices, we can forecast what will happen to the housing component.

In our model, the new tenant rent index shows the highest correlations with the PCE-imputed rental of owner-occupied housing component three quarters ahead of time.

The index slowed materially in the third quarter last year, to 2.58% on a year-ago basis from 3.43% previously. The index then posted a whopping 4.74% decline in the fourth quarter.

That implies a further drop in the PCE housing component, to 3.19% in the second quarter this year and to 2.34% in the third quarter—much lower than the 6.34% recorded in the fourth quarter of last year.

That should shave off 0.04 of a percentage point from PCE inflation each month, equivalent to at least 0.5 of a percentage point on an annualized basis. That decline would bring inflation back to 2% or below by midyear, barring any unexpected shock.

Is the Fed falling behind the curve again?

We believe there is room for a constructive debate on what the Fed should do and what it will do. From our point of view, the two might not perfectly align once everything plays out over the next six months or so.

In theory, monetary policy should be forward-looking, not backward-looking. Given our new findings and what all leading indicators are pointing to, the Fed should reduce its policy rate sooner rather than later.

The path to the neutral rate should progress much more quickly than what the Fed’s Summary of Economic Projections indicated in December.

If the Fed continues to be data-dependent, the chance of being behind the curve is nontrivial.

In retrospect, the central bank was behind the curve—as Fed officials acknowledge—when it came to predicting inflation during the pandemic.

The Fed must ensure that it does not repeat that mistake as inflation abates and returns to the 2% target.

The key risk is that while rates have been effectively restricted to combat inflation, in many sectors of the economy, businesses are facing elevated borrowing costs, hampering investment appetites.

A greater risk looms in the corporate debt markets, as $3 trillion to $3.5 trillion in corporate debt will need be refinanced into 2025. This is in addition to the stress in the commercial real estate market as building owners grapple with plunging values.

In our recent special report on corporate funding, middle market businesses, which make up most of the real economy and total employment, are facing double-digit interest rates to fund their business expansion. That is not sustainable as the economy decelerates from last year’s robust growth.

But as always, the Fed faces a balancing act, and to risk a rebound in inflation by cutting rates prematurely would further damage the Fed's credibility, which is its most important asset when it comes to shaping market expectations on inflation.

That is a hard-earned lesson from the great inflation of the ’70s and ’80s.

In addition, the robust labor market and above-trend growth that defined last year’s economy, and the wage and service inflation that remains markedly above the target rate, should give anyone pause before calling for a large number of rate cuts.

Timing matters

Finding the right timing is never easy when it comes to monetary policy. The good news is that the margin for error this time around seems more forgiving.

That margin of error is reflected in what the Fed is thinking about—roughly three to four rate cuts of 25 basis points—versus what the market wants—slightly more than five cuts this year. The difference is only a handful of basis points.

The reason is that the economy is on an encouraging path to achieving a soft landing, which has rarely happened in the past. The shifts in demographics, globalization and industrial policies are contributing to one of the strongest labor markets in history.

The invention and wide adoption of artificial intelligence, particularly generative AI, should also facilitate over the medium term what we think is a budding productivity boom.

That is a potential game changer for the economy, representing the mythical rising tide that lifts living standards for all while lowering the overall price level.

The takeaway

For the Fed, that means it can move in a deliberate fashion to meet its objectives in an orderly fashion rather than moving fast and creating additional risk through the policy channel.