Extending the runway to achieve the inflation target

Chief Economist Eugenio J. Alemán discusses current economic conditions.

Since we are not going to publish Weekly Economics on December 27, 2024, we will take this opportunity to say farewell to 2024 and to all our readers, we want to wish you a very happy holiday season and a very prosperous New Year 2025!

Although we expect 2025 to be another good year for the U.S. economy, it will not be without its challenges, just as we had during 2024. For one, the rate of inflation, while much closer to the Federal Reserve (Fed) target, will remain higher than the 2.0% target, which means that the Fed will have to continue to recalibrate its monetary policy stance. As we saw after the Federal Open Market Committee (FOMC) meeting this week and as we argued in Weekly Economics last week, the current and expected monetary policy path, that is, the one shown by the September dot plot, is no longer conducive to the achievement of the 2.0% inflation target and thus we expected the Fed to change its interest rate path to two rate cuts next year, from four estimated in September, and two cuts during 2026.

The path for monetary policy in 2026 is so far away that it is not that relevant at this time. But the path for monetary policy in 2025 is very relevant and although we think the Fed did the right thing in lowering expectations for rate cuts in 2025, the actual change in rates will remain in flux because economic activity continues to defy expectations and continues to make the Fed’s job of bringing inflation down to the 2.0% target more challenging. Even though we expect overall growth in 2025 to be below overall growth in 2024, we are still expecting growth to be above trend and that has the potential to keep the rate of inflation north of the 2.0% target.

Although the Fed did not need a recession to bring down inflation, the path to the 2.0% target becomes more difficult if the economy continues to grow at current rates or if it stays above potential economic growth, as we expect it will over the next several years.

At this time, Fed officials seem to be okay with extending the runway for the soft landing, that is, pushing the achievement of its policy target into 2027 in order to give an opportunity for the economy to slow down and help inflation to come down. However, it is unknown if markets and/or political pressures will give the Fed such a long runway or if they are going to start pushing the Fed to do more to bring down inflation and with a faster schedule, in which case even two cuts in 2025 may not come to fruition. It is true that Fed officials seem to think that the current path is going to allow them to hit the target, but two more years seems to be a rather long period of time in terms of achieving an inflation target that has been so close.

The Fed is probably betting that higher long-term interest rates even if it continues to lower the federal funds rate will keep mortgage rates relatively high and help extend the runway in order to buy time for inflation to continue to move down. The risk is that higher interest rates for longer will add more pressure to the fiscal accounts, as interest payments on the debt will continue to take a larger bite at tax revenues and become an even more serious issue.

PCE price index better than expected in November

The release of the PCE price index earlier today was a bright spot after the disappointing reaction from markets to the change in the path of interest rates declines announced after the conclusion of the FOMC meeting earlier this week. Although this release may be prone to revisions in the coming quarters due to the timing of the release, which occurred more than a week earlier due to the holidays, the overall report was good and should tend to calm market anxiety (See the indicator in the pages below).

Changes to our forecast

We have made changes to our forecast in order to reflect several factors over the last few months. From a monetary policy perspective, we have changed our forecast for the number of rate cuts in 2025 to two 25 basis points cuts compared to our previous four cuts. For 2026 we also have two rate cuts.

In terms of economic growth, we have increased economic growth slightly in 2025 while leaving growth for 2026 unchanged. At the same time, we have increased our forecast for the PCE price index to reflect a slower pace for the ongoing disinflationary environment. For a complete view of the changes, please see the forecast table on the next page.

Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those of Raymond James and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur. Past performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Statistics. Currencies investing is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample.

Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.

The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100.

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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren't part of this index.

Employment cost Index: The Employment Cost Index (ECI) measures the change in the hourly labor cost to employers over time. The ECI uses a fixed “basket” of labor to produce a pure cost change, free from the effects of workers moving between occupations and industries and includes both the cost of wages and salaries and the cost of benefits.

US Dollar Index: The US Dollar Index is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies. The Index goes up when the

U.S. dollar gains "strength" when compared to other currencies.

Import Price Index: The import price index measure price changes in goods or services purchased from abroad by U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).

ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers' Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.

Consumer Price Index (CPI) A consumer price index is a price index, the price of a weighted average market basket of consumer goods and services purchased by households.

Producer Price Index: A producer price index(PPI) is a price index that measures the average changes in prices received by domestic producers for their output.

Industrial production: Industrial production is a measure of output of the industrial sector of the economy. The industrial sector includes manufacturing, mining, and utilities. Although these sectors contribute only a small portion of gross domestic product, they are highly sensitive to interest rates and consumer demand.

The NAHB/Wells Fargo Housing Opportunity Index (HOI) for a given area is defined as the share of homes sold in that area that would have been affordable to a family earning the local median income, based on standard mortgage underwriting criteria.

Conference Board Coincident Economic Index: The Composite Index of Coincident Indicators is an index published by the Conference Board that provides a broad-based measurement of current economic conditions, helping economists, investors, and public policymakers to determine which phase of the business cycle the economy is currently experiencing.

Conference Board Lagging Economic Index: The Composite Index of Lagging Indicators is an index published monthly by the Conference Board, used to confirm and assess the direction of the economy's movements over recent months.

New Export Index: The PMI New export orders index allows us to track international demand for a country's goods and services on a timely, monthly, basis.

Gold is subject to the special risks associated with investing in precious metals, including but not limited to: price may be subject to wide fluctuation; the market is relatively limited; the sources are concentrated in countries that have the potential for instability; and the market is unregulated.

The Conference Board Leading Economic Index: Intended to forecast future economic activity, it is calculated from the values of ten key variables.

Source: FactSet, data as of 12/6/2024