The Fed’s view that the recent high inflation figures were transitory must now be reassessed. After a third consecutive month of price increases and the recent surge in energy costs, rate cuts are indefinitely on hold, and the likelihood that the Fed will not be able to lower its rates at all in 2024 is increasing significantly.

The latest consumer price inflation figure in the United States blows apart the logic that rate cuts would be expected in the near future. The core CPI remained below 4%, double the Fed’s target. This will negatively impact the Fed’s preferred indicator, pushing these figures up and making the Fed’s 2% target difficult to achieve in the near future.

The Federal Reserve likely misjudged the situation, still thinking as recently as last month that three rate cuts were likely this year. It overestimated shocks related to productivity and labour supply, thinking they would dampen inflation even in the face of deficit spending. However, too many secular trends keep inflation at a high level. So, the Fed will either have to accept higher inflation, delay its rate cut projections, or both. This will significantly impact the value of government bonds and risky assets.

Indeed, the US economy is robust. It has consistently outperformed all expectations since the Fed began raising rates. Based on early April data, this quarter will again be exceptional, with growth close to 2.5%.
So far, the Fed’s narrative has been that economic growth and inflation would moderate, leading to a soft landing for the US economy that would allow the Fed to lower rates and sustain economic growth indefinitely. However, after the latest data, this narrative no longer holds up. In simple terms, the US economy is more dynamic than the Fed thought.
I favour another explanation: monetary policy may not be so tight. In other words, the neutral interest rate adjusted for inflation, the level that neither stimulates nor restrains growth, is higher than the Fed officials’ estimate. This would mean that the current federal funds rate is less restrictive for growth. The argument finds justification in significant budget deficits and public investments for a decarbonized economy. Added to this is the end of Globalization, which was a deflationary phenomenon. The rise of protectionism and the emergence of regionalization in the global economy adds further weight to this explanation. These factors, some of which are structural, have pushed up the neutral interest rate. If this is the case, the Fed should keep rates higher for longer, even raise them to seek a neutral rate for the economy.
Furthermore, the war in Ukraine has alerted governments worldwide to the need to invest in defence. The United States and its allies must invest nearly $10 trillion to rearm. Much of these expenditures would be recycled in the United States through purchases from the defence industry, adding to demand pressures on the US economy.
Developments in the situation may lead the Fed to maintain high rates well beyond June, even to raise them, a scenario not currently envisaged by investors.

The problem is not just that inflation remains persistent but that it could reaccelerate. Firstly, all inflation indicators are red: core PCE is at 2.8%, overall CPI is at 3.5%, and underlying CPI is at 3.8%. Without a decrease in these data, which seems unlikely given the underlying price increases, the chances of three rate cuts this year starting from June are slim. In the coming weeks, the Fed will likely reconsider its position and prepare the market for an average of two rate cuts. In the end, we will get one or zero cuts this year. And this is the most optimistic scenario.
Because inflation is stuck at uncomfortable levels and under other circumstances, it could even lead to rate hikes by the Fed. Nevertheless, the Fed’s communication suggests it is uncomfortable with the credit tightness for economically vulnerable small businesses and low-income households. Credit tightening has been exacerbated by the situation of regional banks lacking capital since the explosion of the SVB. If the US economy is resilient, it will remain fragile. On the business side, figures released last week showed the gloominess of small businesses, with confidence at its lowest in 11 years.

As explained earlier, secular trends favour persistent inflation. Several trends disrupt the supply side’s argument for a return to 2% inflation and contribute to maintaining high inflation. This means that rates should stay higher for longer at best.