Expectations on interest rate cuts are being dialed back as 2024 inflation data through March has exceeded expectations so far. Within inflation data, there are two major components that the Federal Open Market Committee policymakers will want to see move lower to perhaps justify cutting interest rates. However, jobs market data also remains a potential wildcard.
Shelter Costs
Perhaps the greatest recent surprise within the Consumer Price Index inflation report is shelter costs. They rose at a 5.7% annual rate to March 2024, according to the most recent CPI report. These costs have seen some disinflation from an 8% annual increase in early 2023 but remain elevated. In contrast, the Zillow Observed Rent Index rose 3.6% for the year to March 2024, a significantly lower rate of growth than the CPI data is reporting.
However, the Zillow index peaked at almost 16% in 2022, whereas CPI shelter costs only ever rose to half that level in 2023. It appears that due to the statistical approach used, CPI shelter costs follow market rates with a considerable lag of perhaps 12 to 18 months.
If shelter costs were to move lower, that would likely bring CPI inflation down, too. That’s because shelter carries a 36% weight in the CPI series, so every 1% decline in shelter inflation reduces reported CPI 0.36% all else equal. Hence, with headline CPI at 3.5% for March 2024, if shelter cost inflation within the CPI were to match what Zillow were reporting for March, that alone would bring inflation halfway to the FOMC’s 2% annual inflation target from its current level.
Energy Prices
The second major concern is energy prices. The FOMC often aims to look through volatility energy price trends by examining a measure of core inflation that excludes food and energy costs.
However, WTI crude has risen from a little more than $70 a barrel in December to $85. Even though the FOMC can strip out that jump from its inflation analysis, the price increase impacts many other goods and services.
For example, rising energy costs can increase the prices of transportation and electricity elsewhere in the economy as well as oil derivatives being a feedstock for many industrial processes. Therefore, easing oil prices could be a material factor in creating incremental disinflation for the U.S. economy. We haven’t seen that yet in 2024. However, it should be noted that though oil costs are rising, the cost of natural gas has fallen sharply in 2024.
The Jobs Market
Inflation moving lower could enable the FOMC to cut interest rates but there’s another factor. Policymakers have been clear that what Fed Chair Jerome Powell has called “real strength” in the U.S. jobs market has enabled them to be patient in holding rates high and waiting for the disinflation that they want to see.
If the jobs market were to worsen, then that might accelerate the FOMC’s plans to cut interest rates. That’s in part because the FOMC has a dual mandate to control inflation and promote full employment. However, rising wage costs have also fueled inflation to some degree. If the job market were to weaken, wage pressure also might ease, which would itself perhaps help move inflation lower.
Jerome Powell said that the Fed “will need greater confidence that inflation is moving toward 2%,” at the Washington Forum on the Canadian Economy on April 16. Powell also indicated that recent data has not provided that confidence. “If higher inflation does persist, we can maintain the current level of restriction for as long as needed,” Powell said.
For now, the FOMC is not comfortable cutting interest rates, as the disinflation seen in 2023 appears to have stalled somewhat based on early 2024 data. However, disinflation in shelter costs and some moderation in energy prices have the potential to move the inflation series closer to the FOMC’s 2% annual target. Beyond that should weakening jobs market occur, it could force the FOMC’s hand in prompting an interest rate cut even before the 2% annual inflation goal appears likely.
