Earlier this month, Federal Reserve Governor Christopher J. Waller’s comments hinted at what could be expected from the upcoming Federal Open Market Committee meeting scheduled for January 30-31. Waller’s balanced approach toward maintaining stability in the economy and managing inflation suggests that the Fed may not be in a hurry to cut rates. “With economic activity and labor markets in good shape and inflation coming down gradually to 2 percent, I see no reason to move as quickly or cut as rapidly as in the past,” Waller said during comments at the Brookings Institution.
The latest inflation trends have been moving in the right direction, though still not at the Fed target of 2.0%, and the Fed has yet to see evidence that the inflation trend is sustainable. Waller made it clear in his remarks that he believes that financial conditions are adequately restrictive to slow economic activity enough to bring down inflation. But he also emphasized that the risk is in lowering rates too rapidly going forward, and any rate adjustments should be data-driven.
As the markets await Fed Chair Jerome Powell’s comments following the upcoming meeting, it is essential to recognize significant develops over the last month that have created headwinds for the continued trend of rapid disinflation and, therefore, are likely to create a more cautious Fed than what Powell demonstrated at the last meeting.
Geopolitical Risk Rising
Geopolitical risks have created a challenging environment for global trade, particularly affecting the shipping industry. Houthi rebels are disrupting global trade in the Red Sea, adding potential headwinds to disinflation. The rebels have been attacking merchant ships traversing the Red Sea heading to or from the Suez Canal.
These attacks by the Houthis operating out of Yemen have forced significant amounts of critical shipping traffic to be diverted around Africa, bypassing the Red Sea and the Suez Canal, adding considerable time, distance, and cost to shipping goods. Time delays clogged supply chains during Covid-19, creating shortages and higher prices. We are starting to see time delays change producer timelines due to the latest conflict in the Red Sea.
Over the last few weeks, shipping container costs have skyrocketed, according to the World Container Index. The cost of shipping a container has exploded from less than $1,500 for a 40ft container to $3,072. The only time shipping costs increased by a similar magnitude was during the pandemic and the beginning of widespread inflation. High shipping costs contribute significantly to inflation in the United States, and these events will need to be monitored as they relate to impacts on the prices of goods in the U.S.
Consumer Resilience
Despite varying economic challenges, the U.S. consumer remains robust. To slow inflation, Fed policy must slow down consumer spending, especially since consumption accounts for 70% of economic growth. Retail sales numbers for December managed to move to the upside to end a very strong year for consumers. Expectations were for retail sales to grow 0.4% month-over-month, but sales came in hot in December at 0.6% month-over-month growth. Adjusting retail sales for inflation, real growth is still very positive at 0.3%.
Such strong retail sales numbers close out a year of significant consumption risks, making inflation sticky above the Fed target. Inflation in December exceeded expectations, reinforcing the risk that economic activity is still too strong to stabilize inflation at target.
Market Impact
The market aggressively priced in significant rate cuts; however, the probability of a rate cut of 25 basis points between today and May of 2024 has been rapidly falling. The likelihood of a rate cut in March has declined from 90% in late December to 53% as of January 17th.
The probability of a rate cut in May is also beginning to fall. In January, much of the data we have seen thus far indicates that upward pressure on inflation and strong economic activity may continue. Even the consumer taking a break or slowing may do little to offset increasing inflation pressures resulting from geopolitical events and supply chain disruptions that result.
As the economic picture for the end of 2023 comes into focus, it paints a picture of a Fed that may follow Waller in using more cautious, less dovish language, and investors are likely to hear the word “data dependent” a lot as the Fed tempers expectations for significant rate cuts in 2024. While rate cuts are still likely, there are likely to be fewer, and they may not begin until later in the year than the market broadly expects currently.