May Fed Meeting: Stagflation Fears Persist As Fed Holds Rates Steady

In a widely anticipated move, the Federal Open Market Committee has opted to maintain its fed funds interest rate at its current target range between 5.25% and 5.5%.

Interest rates are at 23-year highs, but the Federal Reserve has chosen not to change rates since July 2023.

On Wednesday, the Fed also said it will continue, for now, to allow up to $60 billion in Treasury securities and $35 billion in agency mortgage-backed securities to mature and roll off its more than $7.4 trillion balance sheet per month. However, beginning in June, it will lower the pace of its monthly Treasury security sales from $60 billion to $25 billion.

Stagflation Fears

A combination of pent-up consumer demand, supply chain disruptions and a tight labor market sent inflation soaring to 40-year highs in 2022. The FOMC aggressively raised interest rates in 2022 and early 2023 to bring down inflation, and its efforts initially paid off in 2023.

However, after trending lower throughout most of last year, inflation seems to have stiffened in 2024, leading to renewed fears the economy could slip into stagflation.

Stagflation is a phenomenon in which economic growth slows but inflation remains elevated. Given the Fed’s lack of progress in bringing down inflation so far this year, many investors now believe the FOMC will not pivot to rate cuts until late 2024.

“Inflation has eased over the past year but remains elevated. In recent months, there has been a lack of further progress toward the Committee’s 2 percent inflation objective,” the FOMC said in its statement.

The Inflation Tightrope

The Federal Reserve is attempting to bring down inflation by maintaining relatively high interest rates without tipping the U.S. economy into a recession. However, navigating a “soft landing” for the economy may prove difficult because higher interest rates increase borrowing costs for both companies and consumers, slowing economic activity.

In April, the Labor Department reported the consumer price index, or CPI, rose 3.5% year-over-year in March, up from a 3.2% annual gain in February and above economist estimates of 3.4%.

Later in the month, the Commerce Department reported the core personal consumption expenditures price index, or core PCE, was up 2.8% in March, in-line with its 2.8% year-over-year gain in February and above economist estimates of a 2.7% gain.

Core PCE is the Federal Reserve’s preferred inflation measure, and its long-term target for core PCE inflation is just 2%.

Labor Market and Personal Savings

So far, the U.S. labor market has remained resilient, giving the FOMC more leeway to keep monetary policies tight.

In March, the Labor Department reported:

• The U.S. economy added 303,000 jobs in March, well above economist expectations of 200,000 new jobs.
• U.S. wages were up 4.1% year-over-year in March as well.

Higher wages increase labor costs for companies, which often choose to pass those costs on to consumers by raising prices on goods and services.

To further complicate matters, U.S. GDP growth dropped to just 1.6% in the first quarter, down from 3.4% in the fourth quarter and well below the 2.4% growth economists were anticipating.

Investors now fear all the Fed’s tightening measures over the past two years may finally be starting to have a cumulative negative impact on the U.S. economy.

The U.S. personal savings rate dropped to just 3.2% in March, down from 5.2% a year ago, a potential sign inflation and elevated interest rates are weighing on consumers.

“We are prepared to maintain the current target federal funds rate for as long as appropriate,” Fed Chair Jerome Powell said in his post-meeting press conference on Wednesday.

“We’re also prepared to respond to an unexpected weakening in the labor market.”

Economic Outlook

Federal Reserve economists were anticipating a slowdown for the U.S. economy in 2024 even prior to the recent release of the preliminary first-quarter GDP growth estimates.

In March, Fed officials projected three interest rate cuts in 2024, but investors will not know how much that outlook has changed until the FOMC updates its economic projections during its June meeting.

The committee currently projects:

• A 2024 U.S. unemployment rate of 4%, above the 3.8% current unemployment rate the Labor Department reported in March.
• 2.1% GDP growth for the full year in 2024 and only 2.0% GDP growth in 2025.
• Core PCE inflation of 2.6% this year, still well above the Fed’s 2% target.

The Stock Market

The stock market got off to a strong start in 2024 thanks in large part to expectations for Fed rate cuts to begin in the first half of the year. However, the S&P 500 snapped a five-month winning streak in April as investors have grown concerned about the fallout from sticky inflation and weakening U.S. consumers.

The stock market could also struggle from seasonal weakness given the six-month period from May through October has historically been a relatively weak stretch for the S&P 500.

S&P 500 companies are on track to report 3.5% earnings growth in the first quarter, the index’s third consecutive quarter of positive earnings growth. Analysts are expecting earnings growth to accelerate to 9.7% in the second quarter.

Despite the stagflation concerns, George Smith, portfolio strategist for LPL Financial, says there’s still reason to believe the Fed can navigate a soft landing.

“There has been a recent negative shift in sentiment, but we typically view this through a somewhat contrarian lens, and do not believe this marks the end of the bull market. We believe resilient breadth metrics, cyclical sector leadership, little, if any, sign of panic in credit or volatility gauges, economic resiliency, and longer-term momentum may signal further strength ahead,” Smith says.

The S&P 500 dipped lower on Wednesday immediately following the FOMC announcement at 2:00 p.m. ET. However, the index quickly recovered, erasing its initial setback and notching a net gain within an hour of 1% off its post-announcement low.

What’s Next?

Investors and central bankers have roughly six weeks of economic data to monitor between now and the next Fed meeting in June, which could have a significant impact on monetary policy.

According to CME Group, markets are currently pricing in just a 34.9% chance the Fed will issue more than one rate cut in 2024 and a 23.9% chance of no rate cut at all this year.

Bill Adams, chief economist for Comerica Bank, says the tapering of the FOMC’s quantitative tightening program could be psychologically bullish for stock and bond prices, but it likely won’t move the needle much in the actual market.

“In principle the Fed reductions of its asset holdings were putting downward pressure on bond prices and upward pressure on bond interest rates, since they forced private investors to buy more government bonds, and private investors would demand lower prices (higher interest rates) to make those purchases,” Adams says.

“But in practice, interest rates on longer-maturity government bonds are still exceptionally low relative to shorter-maturity bonds, so the Fed ceasing the run-off of the bond portfolio seems unlikely to give long bond prices much of a boost.”

In the near term, investors will be watching the April U.S. jobs report on May 3 for an update on how elevated interest rates are impacting the labor market. In addition, the April CPI inflation reading on May 15 will hopefully reassure concerned investors the Fed is back on the right track and inflation is trending lower once again.

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