The Fed's Narrowing Path: Why Rate Cuts Keep Getting Pushed Back
Market expectations for Fed rate cuts have shifted dramatically. The 'higher for longer' narrative is winning as inflation proves stickier than hoped.
The Federal Reserve's path forward has narrowed considerably in recent weeks. What seemed like an imminent pivot toward rate cuts has given way to a more cautious stance, as inflation data refuses to cooperate with the optimistic narratives that dominated late 2023. Forecasters have substantially repriced their expectations, and the implications ripple through every corner of financial markets.
The Pivot That Wasn't
Just weeks ago, markets were pricing in a near-certainty of rate cuts beginning in March. That confidence has evaporated. Current forecaster sentiment puts the probability of a March cut at roughly 35% - a dramatic shift from the 50%+ expectations that prevailed entering the new year.
The culprit is stubbornly persistent inflation. While headline numbers have fallen dramatically from their 2022 peaks, the "last mile" to the Fed's 2% target is proving treacherous. Services inflation, driven by robust wage growth and a tight labor market, refuses to cool as quickly as goods prices did.
Core inflation metrics that strip out volatile components suggest underlying price pressures remain elevated. The Fed watches these closely, and they don't yet tell the story policymakers need to hear before easing.
The Soft Landing Paradox
Ironically, the delay in rate cuts reflects economic strength rather than weakness. Recession fears have faded substantially - forecasters now put the probability of a 2024 recession at just 28%, down from 35% a month ago and well below the near-certainty many predicted in 2022.
The labor market remains robust. GDP growth exceeded expectations throughout 2023. Consumer spending has proven resilient despite higher borrowing costs. The economy has absorbed the most aggressive tightening cycle in decades without breaking.
This creates a paradox for the Fed. The same economic resilience that has reduced recession risk also provides cover for maintaining restrictive policy. If the economy can handle current rates without significant damage, why rush to cut before inflation is decisively defeated?
What the Markets Are Telling Us
The aggregated view of forecasters reveals a few key conclusions:
First, the inflation fight isn't over. Expectations for hitting the 2% target in 2024 sit at roughly 45% - essentially a coin flip. The Fed's credibility, hard-won through painful rate hikes, depends on not declaring victory prematurely.
Second, the economic outlook has improved. The "soft landing" scenario - where inflation falls without a recession - has moved from hope to baseline expectation. This is remarkable given where we stood 18 months ago.
Third, timing uncertainty has increased even as directional certainty has risen. Most forecasters believe rate cuts will come eventually, but the when has become much murkier than the whether.
The Path From Here
The Fed finds itself threading a needle. Cut too soon, and inflation could reaccelerate, requiring another painful tightening cycle. Wait too long, and the cumulative impact of high rates could finally tip the economy into recession.
Chair Powell has emphasized data dependence, but the data are sending mixed signals. Strong employment argues for patience. Easing financial conditions (rising stock prices, tighter credit spreads) do some of the Fed's work for it. But lagged effects of prior hikes continue working through the system.
The most likely path is a gradual pivot beginning in mid-2024, with the exact timing dependent on inflation readings in the coming months. Markets should prepare for volatility around each CPI release and Fed meeting as the battle between "higher for longer" and "imminent cuts" continues to play out.
What's clear is that the easy phase of the inflation fight - watching headline numbers fall from 9% - is over. The difficult work of grinding back to 2% while preserving economic gains has begun. The Fed's narrowing path leaves little room for error in either direction.