Fed Holds Rates Steady and Signals Easing Policy Ahead as Inflation Continues to Cool

Key Takeaways:

• The Federal Open Market Committee (FOMC) held the federal funds rate at its current target range of 5.25-5.5 percent at its December 12-13 meeting. In the new Summary of Economic Projections (SEP), all FOMC participants expect no future rate hikes, and the median participant expects the federal funds rate to be 4.6 percent by the end of 2024, implying three 25-basis point cuts, one additional cut compared to the September SEP.
• The Consumer Price Index (CPI) increased 0.1 percent in November and was up 3.1 percent compared to a year ago, according to the Bureau of Labor Statistics (BLS). Energy prices provided a strong drag for a second consecutive month, falling 2.3 percent as prices for gasoline were down 6.0 percent. Excluding food and energy, core CPI continued to be elevated, rising 0.3 percent over the month and 4.0 percent compared to a year ago, though this is due in part to lagged measures of shelter inflation, which rose 0.4 percent in November, and an unexpected 1.6 percent rise in used car and truck prices that will likely reverse next month. Medical care services also jumped 0.6 percent, their largest monthly gain since September 2022.
• The Producer Price Index (PPI) was flat in November following a 0.4 percent decline in October, according to the BLS. Compared to a year ago, the PPI is up just 0.9 percent. Excluding food, energy, and trade services, core PPI increased 0.1 percent for the second consecutive month, bringing the year-over-year rate down three-tenths to 2.5 percent, the slowest annual rate since February 2021.
• Retail sales and food services increased 0.3 percent in November following a modest downward revision to October, according to the Census Bureau. The headline gain was despite a price-related 2.9 percent drop in gas station sales. Strong categories included motor vehicle and parts dealers (+0.5 percent), nonstore retailers representing primarily online sales (+1.0 percent), and restaurant and bar sales (+1.6 percent). Control group retail sales (excluding auto, building supplies, and gas station sales), which feed into the personal consumption expenditures for GDP, rose 0.4 percent but were downwardly revised in October from a 0.2 percent gain to flat.
• Industrial production, a gauge of output in the manufacturing, utility, and mining sectors, rose 0.3 percent to 102.7 in November, according to the Federal Reserve Board. Manufacturing activity rose 0.4 percent to 99.2 and mining output rose 0.3 percent to 119.2. Utilities output, which depends heavily on the weather, declined 0.4 percent to 104.8.
• The National Federation of Independent Business (NFIB) Small Business Optimism Index declined one-tenth to 90.6 in November. On net, negative 3 percent of firms plan to increase inventories, a decline of 3 points and the lowest share since June, while negative 8 percent of firms expect real sales to be higher in the next six months, an improvement of 2 percentage points and the highest share in a year. Inflation remained the single most important problem for 22 percent of businesses, while quality of labor had the plurality of votes at 24 percent.

Forecast Impact:

Inflation data again came in generally cool in November. Core inflation does remain elevated but this is due in large part to measures of shelter inflation that lag more timely measures of newly signed leases by four to five quarters – the BLS’ new tenant rent index, a research series that measures rent data if tenants moved in every period, showed rent prices were up just 2.8 percent compared to a year ago through the third quarter, compared to the 6.5 percent year-over-year rate for shelter costs in the CPI in November. As newly signed leases continue to flow through to the CPI measure of rent, we expect core inflation will continue to drift back toward 2 percent. Recent favorable inflation data coincides with the more dovish turn from the FOMC, which has removed any additional rate hikes and added an additional rate cut next year in their latest SEP. Futures markets are currently pricing in even more cuts than the Fed currently shows, but given the possibility of a resurgence in inflation if the Fed eases policy too quickly, we expect officials to err closer to their current projections than what markets are currently expecting.

Control group retail sales came in a bit stronger than expected, though this was offset somewhat by a downward revision to October data. While consumer spending growth is still on track to slow from its third quarter pace, this likely implies a bit more consumer strength in the fourth quarter than we had currently forecast. The modest growth in manufacturing output in the industrial production report is likely due in part to the return of workers from the United Auto Workers strike. Still, manufacturing activity has hovered in the same tight range for all of 2023, signaling relative stagnation in the sector.

Nathaniel Drake
Economic and Strategic Research Group
December 15, 2023

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