The Fed approaches a turning point

The Federal Open Market Committee (FOMC or Fed) left its key policy rate unchanged at the January 31 meeting, but it is now clear that the next move is down, and the only question is how soon. As recently as December 13 of last year, the FOMC statement referred to "additional policy firming that may be appropriate." That language was dropped in January and replaced by language saying that the Fed will reduce the policy rate when it is more confident that inflation is heading sustainably toward its 2 percent target.

The release of the December employment cost index (ECI) data at the beginning of the second day of the FOMC meeting almost surely had a large impact on the statement. The ECI private sector total compensation index, which had risen 5.1 percent over the 12 months to December 2022, rose only 4.1 percent in the 12 months to December 2023. Moreover, in the latest three months, the ECI rose at an annual rate of only 3.5 percent. That is a dramatic reduction in wage growth considering that the unemployment rate of 3.7 percent is close to its lowest level since World War II. Wages are the most important driver of the nonhousing services component of inflation, which has been slow to recede. Wage growth is getting very close to a level consistent with the Fed's 2 percent target over time.

At the press conference after the January meeting, Chair Jerome Powell was clearly thrilled with the latest economic news, which also included a report that the US economy grew much faster than expected in 2023. He seemed to have growing confidence that we have avoided a hard landing. He noted that core personal consumption expenditure (PCE) prices grew at the Fed's 2 percent target in the last six months of 2023, but he said that the FOMC wants more assurance that its target will be achieved for a full 12 months and more. One concern is that PCE price inflation is being held down by falling goods prices that are not likely to continue to fall forever.

Powell said a cut in March is "not likely" but did not rule it out. There will be only one more PCE report before the March 20 meeting, though there will be two more consumer price index (CPI) reports. The May FOMC meeting now seems the most likely time for the first rate cut. By that point, the FOMC will have three more months of PCE inflation data and the March ECI report. Should those inflation readings remain anywhere close to their recent levels, the stage will be set to start easing monetary policy.