Recent inflation surprises have left the Federal Reserve without sufficient confidence to consider interest rate reductions, prompting a scenario of higher-for-longer interest rates.
That's the insight coming from Bank of America's U.S. economist Michael Gapen ahead of this week's Federal Open Market Committee meeting and interest rate decision, due at 2 p.m. ET Wednesday.
With no immediate changes in interest rates anticipated, the focus shifts to the Fed's future policy actions, particularly regarding potential rate cuts.
Bank of America Expects Single Rate Cut This Year, No Earlier Than December
In response to higher-than-expected inflation readings, Bank of America has revised its forecast dramatically over the past month. After an initial prediction of three rate cuts, the bank has now adjusted its forecast to a single reduction in December 2024.
That closely reflects the prevailing market sentiment, with expectations leaning toward a modest 35-basis-point rate cut (equivalent to one cut) for 2024, with a 60% chance for a rate cut by September as implied by the CME Group's FedWatch.
Gapen adjusted his terminal rate projection to between 3.5% and 3.75% for 2026. This shift highlights a slower pace of disinflation than previously expected, the economist said.
"We expect the main message from the press conference to be that policy needs more time to work. Powell should indicate the next move is still likely to be a rate cut, but the Fed will be in wait-and-see mode until it achieves confidence it desires on inflation," he said.
Fed Chair Powell's Stance Indicates Fed In No Rush To Cut
The economist recalled what Fed Chair Jerome Powell said on April 16: "The recent data have clearly not given us greater confidence and instead indicate that it's likely to take longer than expected to achieve that confidence," and that "given the strength of the labor market and progress on inflation so far, it's appropriate to allow restrictive policy further time to work and let the data and the evolving outlook guide us."
Last week,the March Personal Consumption Expenditure (PCE) price index - the Federal Reserve's preferred measure of inflation - failed to indicate any improvement in the disinflationary narrative. The headline PCE surged from 2.5% to 2.7% year-on-year, exceeding expectations of 2.6%, while the core PCE remained steady at 2.8% year-on-year, contrary to anticipated declines to 2.6%.
"While the Fed can dismiss some of the recent firmness as noise, it will take on board some signal and conclude disinflation is proceeding at a slower pace," Gapen wrote.
The economist highlighted the adverse base effects on inflation expected in the second half of the year and noted the recent firming in sequential inflation. This development complicates the possibility of rate cuts in the near term, especially by June, he said. Gapen stressed that while some inflation firmness could be noise, there is enough signal to conclude that disinflation is not proceeding as quickly as hoped
Looking ahead, Bank of America does not rule out the Fed turning to rate hikes again, but only if either of two scenarios occurs: an acceleration in core and headline inflation or a rise in inflation expectations. Both scenarios would suggest that supply shocks have ended and the economy might be overheating, Gapen said.
"Whether it is the increase in the labor force pushing potential growth temporarily higher, higher inflation leading the Fed to keep policy more restrictive on the margin, or large fiscal deficits fueling the expansion, we think the right answer is to reduce the number of cuts," he said.
In terms of the Fed's balance sheet, Bank of America anticipates an announcement during the May FOMC meeting about tapering the balance sheet runoff. This would involve reducing the maximum monthly redemption cap on maturing Treasury securities from $60 billion to $30 billion.