Why We Expect the Fed to Remain Cautious

The U.S. economy has demonstrated remarkable resilience, defying expectations despite the Federal Reserve’s efforts to temper growth and control inflation. This favorable outcome, often described as a “Goldilocks” scenario of strong growth coupled with lower inflation, has been driven by a timely expansion in the economy’s supply side. Notable gains in workforce numbers and productivity have underpinned this performance. Consequently, our updated economic forecasts predict stronger growth, a robust labor market, persistent inflation, and a cautious Fed approach toward rate cuts, possibly refraining from any cuts this year.

Supply-Side Dynamics in Focus

Despite high policy interest rates to curb inflation by restraining economic activity, the U.S. economy achieved a surprising 3.0% GDP growth in 2023. This growth was supported by unexpected labor supply and productivity increases, which countered the effects of the Fed’s aggressive monetary tightening. These positive supply-side factors are expected to diminish gradually, leading us to forecast economic growth around 2.0% and an unemployment rate near 4.0% by the end of 2024.

Persistent Demand and Inflation Challenges

The economy’s resilience and robust demand suggest that the final stages of combating inflation will be particularly challenging. We anticipate that the core Personal Consumption Expenditures (PCE) price index, the Fed’s preferred inflation measure, will not smoothly decline to the 2.0% target. Instead, it will likely remain above 2.5% for the year, higher than expected. This core measure excludes volatile food and energy prices.

Cautious Fed Approach

Given persistent inflation above the 2.0% target and the risk of financial conditions easing too quickly, we expect the Fed to proceed cautiously with its first rate cut. It is plausible that the Fed may maintain its federal funds rate in the current range of 5.25% to 5.50% throughout 2024, potentially delaying any rate cuts.
However, a soft-landing scenario involving moderate Fed cuts remains within the realm of possibility. If strong supply-side factors continue into 2024, they could help inflation reach the Fed’s target more swiftly without harming economic growth or the labor market. This would represent a fortunate outcome as Fed policy does not directly control supply-side dynamics. Conversely, while not our primary expectation, a late-year recession remains a possibility if favorable supply-side conditions deteriorate faster than anticipated.

Embracing Sound Money

Current developments reinforce our view that we have entered an era of “sound money,” with interest rates exceeding inflation rates. Maintaining a balanced and diversified investment portfolio is crucial in this environment. Sound money lays a solid foundation for achieving long-term risk-adjusted returns.

This content represents the views of Friends Wealth Management and is intended for informational purposes only.