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Will the Fed Delay Again?

Surprises in inflation and job numbers have investors wondering if the Fed will delay rate cuts for the second time this year.

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Given the strength of the U.S. economy, the Federal Reserve has yet to feel the need to initiate a rate-cut campaign.

Investors had hoped the Fed would start cutting by spring.

Instead, at both its January and March meetings the Federal Open Market Committee (FOMC) left the fed funds rate range unchanged at 5.25% to 5.50%, a 23-year high.

Investors shifted their hopes to June. Now that hope is fading.

While inflation has moderated over the past two years, it stubbornly remains above the Fed’s 2% target.

The core consumer price index (CPI), which excludes food and energy, rose at a 3.8% annual pace in March, higher than many economists had expected. The CPI release came just five days after the Bureau of Labor Statistics had reported the U.S. economy added more than 300,000 jobs in March, while many economists had expected 200,000.

Core services ex shelter inflation accelerated, as auto insurance prices increased. Goods inflation, on the other hand, was somewhat subdued as used car prices declined.

Still, other measures this year have indicated moderating inflation. The core personal consumption expenditures (PCE) index, which the Fed watches closely and excludes food and energy, has trended down since last spring and logged 2.8% in February on an annual basis – though at the writing of this commentary the March PCE figure had not been released.

Inflation Has Slowed, But Remains Above Target
Source: FactSet as of 4/3/24.

Some investors think the Fed may not cut rates at all this year, which is not inconceivable, though unlikely. After the March jobs report, traders generally have been betting the Fed cuts rates once or twice this year.

The Fed’s summary of economic projections (SEP) released in March, before the jobs and inflation surprises, indicates three rate cuts this year. The SEP also forecast three cuts in both 2025 and 2026.

The All-Important Job Market

Fed officials have acknowledged that if they cut rates too early they risk reigniting inflation. On the other hand, some Fed officials also realize constricting monetary policy too tightly and too long could stall economic activity. Given that the U.S. economy is mainly driven by consumption, the health of the labor market remains critical in supporting spending and economic activity more broadly.

Despite the announced layoffs within the tech sector over the past several quarters, the unemployment rate remains below 4% and jobless claims have yet to show signs of weakness in the labor market.

To no surprise, the hot labor market was one of the main contributors to the rise in inflation we saw in recent years. Coming out of the pandemic, many companies aggressively hired workers as stimulus checks were distributed and economic uncertainty started to abate. This ultimately created an environment that led to many dissatisfied workers quitting for various reasons, also referred to as the Great Resignation. Whether people quit to retire, relocate, and/or find better opportunities, the competition among employers to fill vacancies led to higher wages. The combination of stimulus checks and higher wealth created by robust stock and real estate markets encouraged some of the older and experienced workers to leave the workforce. In turn, employers in industries that experienced high quit rates responded by raising wages to rebuild their staff.

Eventually, the stimulus savings shrank, and economic activity slowed as the Fed aggressively raised interest rates. Now, conditions have changed; workers are embracing their jobs, and the quit rate has reversed to levels normally seen during recessionary periods.

The Great Resignation Is Over
Source: FactSet as of 2/29/24.

This should mean that services inflation, which was the main driver of inflation, is likely to continue its downward path, despite an uptick in March due to a rise in auto insurance costs. While hiring activity has slowed over the past several quarters, the labor market appears to be stabilizing rather than deteriorating, as the unemployment rate remains low and job openings remain relatively high compared to past levels. These conditions should hold as long as business and consumer confidence remain healthy. The deceleration in inflation has boosted consumer sentiment, which tends to dictate future retail spending.

Consumers Feel Better About the Economy
Source: FactSet as of 3/29/24.

A Likely Soft-Landing

For the time being, it appears that the Fed may be close to achieving the elusive soft-landing scenario. Despite the aggressive rate hikes, the U.S. economy has yet to meaningfully slowdown.

Despite the solid economy, one reason the Fed may want to cut rates is to soften the blow from the coming debt maturity wall. This is when large amounts of debt mature, and borrowers will need to either pay back their loans or refinance their debt. This is particularly a concern within the commercial real estate (CRE) sector. A recent Fitch Ratings study showed that less than half of CRE borrowers would be able to refinance their debt due to mature this year (mainly because of higher interest rates). Unless interest rates fall, CRE default rates will likely continue climbing, which will force banks to take more losses.

Loan Losses Are Creeping Up at Banks
Source: FactSet as of 12/31/23.

Nevertheless, if the Fed starts to cut rates before debt maturities come due, then some of the pressures should dissipate. Lower rates should help keep debt delinquencies under control and prevent a systemic deterioration in the economy. If inflation continues to normalize to the Fed’s target rate, Powell and his fellow Federal Open Market Committee members may engineer a successful rotation in the economy and avoid a spiraling downturn.

Investment Implications

For now, the probability of a recession has fallen to a point where we have begun to take on more equity risk in our portfolios. Instead of making aggressive moves at this point, we are taking calculated risks until we have more clarity. While conditions are steadily improving, we realize much will depend on how the Fed addresses the various risks on the horizon. As always, we will continue to monitor these risks and adjust our allocations accordingly.

Definitions:

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 Johnson Redbook Index is a sales-weighted of year-over-year same-store sales growth in a sample of large US general merchandise retailers representing about 9,000 stores.

The JOLTS report or Job Openings and Labor Turnover Survey is a report from the Bureau of Labor Statistics measuring employment, layoffs, job openings, and quits in the United States economy.

The Michigan Consumer Sentiment Index (MCSI) is a monthly survey of consumer confidence levels in the United States conducted by the University of Michigan.

Personal Consumption Expenditures (PCE) 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.

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.

Aristotle Funds and Foreside Financial Services, LLC are not affiliated with Pacific Life Fund Advisors LLC.

Foreside Financial Services, LLC, distributor.

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