Investors, consumers and business leaders have been closely tracking the U.S. Federal Reserve’s interpretation of economic data, waiting for the moment when the economy has slowed enough to allow the Fed to cut interest rates for the first time since it began raising them in March 2022. So far, they have waited without result: Recent data has shown that economic growth has remained strong. Namely, inflation continues to be stubborn, with a surprising upswing in the price of goods and services in the first few months of the year.
However, despite the first-quarter reacceleration in inflation, price increases should start to slow down as the second half of the year begins, clearing the path for rate cuts. The Fed will need to feel confident that there won’t be any inflation surprises before it makes its first move, likely making June or July too early to begin the trim cycle. Morgan Stanley Research expects three cuts this year, of 25 basis points each, starting in September.
Our analysis is based on two factors:
Easing price pressures: Investors who were primed for a March rate cut were disappointed early in the year by inflation data that showed surprising upswings in the prices of goods such as apparel and computer software, as well as for financial services. Indeed, on a three-month annualized pace, the Fed’s preferred measure of inflation, core personal consumption expenditures inflation—which includes costs for housing, utilities, healthcare and recreation—accelerated from 1.6% in December 2023 to 4.4% in March 2024.
We expect price inflation in these areas will start to ease, and that rent and car insurance, in particular, will continue to come down. The data over the summer should start to give the Fed more confidence to begin whittling rates starting at the September Federal Open Market Committee meeting.
Coming slack in jobs and growth: A surge in immigration last year boosted the country’s labor supply and helped expand the economy. This helped explain the intellectual conundrum of rapid growth despite moderating inflation of 2023—and the resulting bigger, not tighter, U.S. economy.
But recent jobs data hint at a softening trend, with weaker hourly earnings, higher unemployment and lower-than-expected payroll prints for April. Demand for workers appears to be slowing and uncertainty over future job prospects is likely to keep employees in place. Fed Chair Jay Powell has indicated material weakening in the labor market would be a reason to trim rates, and Morgan Stanley believes the unemployment rate this year will increase more than the Fed expects, ending at 4.2%. The coming jobs data should support our view for a September start to rate cuts, with two additional cuts in November and December.
