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Is Fed on the Cutting Edge?

The market expects the central bank to cut rates in early spring; the Fed may have other ideas.

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The Federal Reserve paused interest-rate hikes during the last three Federal Open Market Committee (FOMC) meetings of 2023, and unless inflation pressures resurface, the Fed is likely finished with its rate-hiking cycle. But when will the widely anticipated rate cuts begin? Currently, the market consensus suggests the Fed will pursue interest-rate cuts sooner than later, with the first one coming as early as March 2024. However, this hinges on core inflation approaching the Fed’s target of 2%. At this point, this goal appears attainable.

Inflation Fell in 2023
Source: FactSet as of 1/4/24.

According to real-time data tracked by the Fed’s Inflation Nowcasting, the core Personal Consumption Expenditures (PCE) Price Index appears to be on track to hit the Fed’s target within the next several months–unless inflation turns out to be stickier than anticipated. Nonetheless, this is further verified by market rent prices having normalized already. Market rent price data (which tends to lead Consumer Price Index—or CPI—shelter data by roughly a year) indicates housing inflation has already normalized in real-time, implying that core CPI and PCE should soon follow.

The Cost of Shelter Has Also Fallen
Source: FactSet as of 12/29/23.

While shelter inflation is set to decelerate and normalize, wage growth remains well above normal levels–though it looks to have peaked about a year ago. Wage growth impacts non-shelter service inflation, which should be the last piece of the puzzle that is keeping inflation elevated. The latest labor market data shows that employment remains quite strong, suggesting that the market might be too optimistic about early rate cuts.

Wage Growth Has Moderated
Source: FactSet as of 11/30/23.

The U.S. economy continues to remain relatively resilient despite 11 rounds of interest-rate hikes since 2022. Unemployment continues to be well below 4%. One of the reasons for the resiliency stems from all the government spending aimed to drive infrastructure, electric-vehicle, and semiconductor production. Additionally, enthusiasm over AI will likely attract considerable amount of private capital toward its development as well. This spending could support the economy and add pressure to inflation.

Some of these potential pressures could cause the Fed to hesitate cutting rates earlier than it has anticipated. Unless these inflationary factors dissipate, the Fed may end up disappointing the market by holding interest rates higher for longer (as Chair Jerome Powell has suggested). Additionally, both consumer and corporate confidence has not deteriorated enough to warrant significant cuts yet.

Furthermore, we cannot ignore geopolitical risks that could potentially reignite inflation. Tensions around the South China Sea has the potential to disrupt global trade, as China continues to flex its military authority in the region and seeks to reunite Taiwan with the mainland. Further decoupling between the U.S. and China would likely have inflationary effects. Additionally, the ongoing conflict in the Middle East and the Red Sea is forcing shippers to find alternative routes around that region, causing shipping costs to spike again.

Geopolitical Conflicts May Add to Shipping Costs
Source: FactSet as of 1/5/24.

Inflationary risks continue to linger, and it may be too early to celebrate. Current signs indicate that the Fed may refrain from aggressively easing monetary policy for the time being, unless FOMC members begin to worry about a hard-landing scenario for the economy. Although the Fed may be done raising rates, it may hesitate from cutting rates too early and aggressively given that deep recessionary risks have been waning. Given this outlook, it may seem too premature to aggressively dial up portfolio risk for now.

The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living.

The Core PCE Price Index measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices to reveal underlying inflation trends.

The Federal Open Market Committee (FOMC) is the branch of the Federal Reserve that determines the direction of monetary policy in the United States

Personal Consumption Expenditures (PCEs) refers to a measure of imputed household expenditures defined for a period of time. Personal income, PCEs, and the PCE Price Index reading are released monthly in the Bureau of Economic Analysis (BEA) Personal Income and Outlays report.

Zillow Observed Rent Index (ZORI) is a smoothed measure of the typical observed market rate rent across a given region.

Any performance data quoted represent past performance, which does not guarantee future results. Index performance is not indicative of any fund’s performance. Indexes are unmanaged and it is not possible to invest directly in an index. For current standardized performance of the funds, please visit www.AristotleFunds.com.

The views expressed are as of the publication date and are presented for informational purposes only. These views should not be considered as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment or market. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant.

Investors should consider a fund’s investment goal, risk, charges and expenses carefully before investing. The prospectus contains this and other information about the fund and can be obtained at www.AristotleFunds.com. It should be read carefully before investing.

Investing involves risk. Principal loss is possible.

Foreside Financial Services, LLC, distributor.

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