The Federal Reserve has spent the better part of two years fighting a war on two fronts — and the battlefield is shifting in ways that make the next twelve months especially consequential.
The Core Problem
Inflation is falling. But not fast enough, and not in the right places.
Goods inflation has largely corrected — supply chains normalized, consumer spending rotated back toward services, and the pandemic-era distortions unwound largely as expected. The stubborn part is services inflation, which is driven primarily by wages and shelter costs, and responds only slowly to monetary tightening.
"Monetary policy works with long and variable lags." — Milton Friedman, 1961 The Fed is still waiting to feel the full effect of 500+ basis points of tightening.
What the Data Says
The last three CPI prints have shown sequential deceleration, but the year-over-year numbers remain above the Fed's 2% target:
- Headline CPI: 3.4% YoY (down from 9.1% peak)
- Core CPI: 3.9% YoY (services ex-shelter still elevated)
- PCE Deflator: 2.7% YoY (the Fed's preferred measure)
The direction is right. The pace is the problem.
The Growth Question
Meanwhile, the US economy has proven far more resilient than most forecasters expected. GDP grew 3.4% in Q3 2023 and 1.6% in Q1 2024 — slowing, yes, but not the recession that would typically accompany this level of rate tightening.
This resilience is a double-edged sword. Strong growth is good news for employment and corporate earnings. But it also means the restrictive policy isn't biting as hard as the Fed would like, which makes premature cuts risky.
What Happens Next
The base case is that the Fed holds rates at current levels through mid-2024, then begins a gradual cutting cycle in the second half of the year — conditional on continued progress on inflation.
The risk case is that services inflation reaccelerates, forcing the Fed to stay higher for longer than markets currently price. The bond market has already repriced this scenario multiple times; Treasury yields have reset higher with each successive "higher for longer" communication from Powell.
The other risk case — one the market is ignoring — is a sharper-than-expected slowdown in the labour market that forces the Fed to cut faster than they'd like, reigniting inflation fears.
Conclusion
The Fed's challenge isn't technical — it's communicative. They need to thread a needle between reassuring markets that cuts are coming (to avoid unnecessary financial tightening) while not triggering a premature easing in financial conditions that reignites inflation.
It's a tightrope. And the wind is picking up.