Macro Signposts | 19 March 2024

This week, I asked Allison Boxer to coauthor Macro Signposts to help preview this week's Fed meeting. Allison is an economist based in New York, focusing on the U.S. and Canada.

Unless explicitly stated, views expressed do not constitute official PIMCO views.

Fed Preview: Hard Data Versus Soft Landing

By Allison Boxer and Tiffany Wilding

The Federal Reserve's already difficult path toward normalizing interest rates and delivering a soft landing for the U.S. economy has been further challenged by resilient growth and sticky inflation. Recent economic data releases for the U.S. - including last week's retail sales, CPI (Consumer Price Index), and PPI (Producer Price Index) reports - reinforced our expectations that the U.S. will likely see above-trend growth and a reacceleration in inflation in the first quarter.

Against this resilient economic backdrop, recent Fedspeak - including semiannual testimony by Chair Jerome Powell - still suggests that the Fed is on track to begin normalizing rates around midyear (most likely June). How do we square this communication and data? A modest increase in the unemployment rate in February has seen the Fed's dual mandate objectives moving in opposite directions. And with core PCE (Personal Consumption Expenditures, the Fed's preferred inflation measure) likely to remain in the "2-point-something" zone, we think this will give the Fed enough room to follow through with a midyear rate cut as it tries to engineer a soft landing for the U.S. economy.

Given this balancing act between resilient data and anticipated rate cuts, we believe the Fed will likely modestly revise its 2024 projections for growth, inflation, and employment at this week's meeting, and it's a close call whether officials' median projection for the policy rate shifts up as well.

Fed projections and rate cut signals
Data have been generally strong since the Fed's January meeting, with inflation in particular showing signs of reacceleration. Last week's CPI and PPI reports confirmed our expectations that core PCE inflation is likely to exceed 3% on a quarterly annualized basis, after 2 consecutive quarters where core PCE was around the Fed's 2% target. Medium term, we still have concerns about the extent to which inflation could fully cool back to the target level without real GDP growth dipping below trend.

Nevertheless, we do believe core PCE inflation will likely remain in the 2-point-something zone, allowing the Fed to proceed with a midyear cut even in the face of resilient activity and reaccelerating inflation. Indeed, recent Fedspeak also seems to set a relatively high bar for delaying the initial cut past this summer, and as such, we think Chair Powell could echo his recent congressional testimony and reiterate that the Fed is not far from having the confidence needed to cut. This would mean June is a reasonable baseline for a first rate cut, though we believe risks remain skewed toward a later or slower start. Meanwhile, markets are now only pricing in about a 50% chance of a cut at the June meeting, underscoring the challenge that stickier inflation is posing to the Fed's path ahead.

Beyond that first cut, the Fed may focus closely on the inflation data as it deliberates the pace and extent of the easing cycle. Rather than the first cut of a presumed series, the Fed may see it as more of a mid-cycle rate adjustment. One concern is that the market reaction to the initial cut could result in more easing in financial conditions than the Fed wants. Communication will be crucial - the Fed may emphasize it could slow, or stop, its rate-cut cycle in an effort to tighten conditions and better control inflation. Or the Fed could decide to tolerate 2-point-something inflation for an extended period rather than risk stifling economic activity too much. It's a balancing act.

Balance sheet in play
With no rate moves and few statement changes likely, tomorrow we'll be focusing on any comments from Chair Powell about the Fed's balance sheet; officials indicated they plan to discuss it at this meeting.

Our expectation is that Dallas Fed President Lorie Logan's 6 January speech will end up being a blueprint for a "taper and extend" approach, in which the Fed slows the pace of Treasury runoff from its balance sheet to allow its quantitative tightening (QT) program to extend for a longer time period. (For details, see our 31 January 2024 Macro Signposts, "The Fed's Balance Sheet Reduction: Outlook, Market Implications, and Potential Strategies.") So far, the QT program hasn't tightened liquidity conditions in the traditional sense - reserves are higher than when the Fed started the program.

We expect a balance sheet announcement around midyear about a gradual tapering in the Treasury runoff while the runoff in mortgage-backed securities (MBS) persists, given that paydowns have continuously run well below the Fed's cap for MBS. The Fed will likely continue to reduce the size of its asset holdings through 2024, and likely into 2025.

Longer-term considerations
We'll also be watching the longer-run dots at this week's meeting, particularly after recent comments by Cleveland Fed President Loretta Mester suggesting that the estimate of the neutral rate could shift higher. We believe the gradual drift higher in individual estimates over the past year may continue, but we don't expect the longer-run median to shift meaningfully higher. We think any questions about longer-run neutral - and whether the resilience of the U.S. economy through this period of high interest rates is an indication of structural economic changes - will be questions for the Fed's 2025 policy framework review.

Read the previous edition of Macro Signposts on takeaways from President Biden's proposed federal budget.

We welcome your questions about the global macro landscape. Don't hesitate to suggest themes or data for us to analyze and discuss: Please email [email protected].

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