US: Inflation’s bumpy ride to 2% has pushed back rate cut hopes substantially. Driven by rebounding shelter and energy prices, US headline inflation moved up to 3.5% y/y in March, a tad higher than expected. While there has been substantial disinflation since the peak of mid-2022, strong demand has kept inflation, headline and core, well above the Federal Reserve’s 2% target. Barring supply side shocks, we see inflation stickiness to abate somewhat in 2H24, although even at the end of 2025, our forecasts remain above 2%. Rate cuts would be fewer than previously envisaged, consequently.

Various measures of inflation converging toward 2.5% would be sufficient for the Fed to ease. The first rate cut in this cycle will not happen before 2H24, something we have been flagging since June last year. However, Fed officials would not want to sacrifice the cycle by ignoring the disinflation so far and fixating only on the remaining work to be done. We think evidence of inflation settling around 2.5% will be good enough for the Fed to begin cutting. Furthermore, we believe the prudent risk management strategy for the central bank would be to cut modestly and gradually, as opposed to by a lot in a short period of time to deal with a recession when it is already too late. We estimate that in the 2020-25 period, core PCE will have risen by a cumulative 15%, which translates into an annualised rate of nearly 2.5%.

Higher for longer. We think that 100 bps of rate cuts in 2H24 are still on the cards, but no longer in the centre of the probability distribution. With growth and inflation both running above trend, it will become increasingly hard for the Fed to cut month after month. A signal that policy has room for normalisation with a 25 bps rate cut would likely be provided in July, in our view, but the next cut will have to wait till 4Q. After 50 bps of cuts in 2024, we think the Fed will continue with quarterly cuts in the following year, taking the policy rate down to 4% by the end of 2025. Stretching the definition of “higher for longer,” we believe communication would be provided that the terminal rate of the cycle, along with the so-called nominal neutral rate or r* is at least 3%, if not higher.

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