Ryan Sweet, chief economist and managing director at Oxford Economics, is convinced that the Federal Reserve is going to cut its key rate as war-driven oil prices peak, taking a big burden off consumers and bringing down inflation over the next several months. That’s the good news.
The less good news for households, businesses, and investors - and for the White House no doubt - is that it’s not going to happen any time soon. Why? Because while the headline inflation numbers “are going to look a lot better over the next several months “the core inflation numbers, which the Fed is really going to be paying close attention to and scrutinizing, unfortunately, I think they’re going to get sticky.”
And it’s not just things like energy prices feeding into fertilizer prices putting pressure on Ryan’s inflation-driving list. “One is AI. AI is actually inflationary in the near term, disinflationary down the road as we get the productivity gains.”
So what does this mean as the new Fed chair Kevin Warsh takes over and as the rest of the Federal Open Market Committee is sharply divided with more and members leaning toward the hawkish side of the monetary policy tilt?
”They’ve got to be patient. They’ve got to kind of ride this out. You know they were patient when the prices were going up. I think on the flip side, you have to be patient with oil prices coming down,” he says. He highlights as a key pressure housing disinflation which he says is going to intensify.
With inflation above its 2% target for five years will the Fed opt for a rate hike this year? Ryan says no, because “we have a very divided Fed and when you have a very divided Fed like this it’s hard to move the committee in one way or another” and policy will be steady through the rest of the year.
”In fact, we’re pushing out the timing of our next rate cut from December of this year to the second half of of 2027, because the Fed is just very, very divided. They’re going to let the data speak. And again, in the end they’re going to want to be patient.”
So dive in and hear why Ryan expects to the Fed to continue to maintan a hawkish tone but not go so far as to hike its key rate.
Spoiler alert: Ryan looks at it this way. “A couple of rate hikes like the market is betting on, that's really not going to make a huge difference on the inflation front. So the risk of a policy error of tightening too soon or overdoing it and pushing the labor market to be increasingly weaker, I think is a risk that the Fed is unwilling to take.”
Oil has peaked relief is coming 00:01:26:20
I think hopefully this is the worst is behind us. I mean they’re since May. Oil prices are down quite a bit. You know looking to the next PCE report gasoline prices should probably be down 10% month over month. So relief is coming but it’s not coming. You know very quickly for consumers.
Relief and yet still there is grief 00:01:46:09
I mean, the average gasoline price in the US is still $1 per gallon higher than it was before the conflict began. And that’s a big financial burden for a lot of consumers, particularly on the low end of the income distribution. But when it comes to inflation, the headline numbers are going to look a lot better over the next several months.
Sticky core inflation will be the problem 00:02:02:06
But the core inflation numbers, which the fed is really going to be paying close attention to and scrutinizing, unfortunately, I think they’re going to get sticky. And it’s not necessarily, you know, because not because, well, prices are coming down. There’s lots of other factors that are propping up core inflation. One is AI. AI is actually inflationary in the near term, disinflationary down the road as we get the productivity gains.
Some problems and trends beyond the Fed’s control 00:02:23:12
But we still have some pass through from past increases in energy prices and to a much lesser extent, some lingering effects of tariffs. So that core goods inflation number is really going to start to stand out in the Fed’s eye because some of it is out of its control. They can’t really control the AI cycle.
Fed must be patient 00:03:27:15
They got to be patient. They got to kind of ride this out. You know they were patient when the prices were going up. I think on the flip side, you have to be patient with oil prices coming down. You want to make sure that some of the core inflation, some of the disinflationary pressures that we’re anticipating, which is primarily through housing, we know the housing disinflation is going to intensify the labor markets roughly neutral.
Nominal wage growth is slow 00:03:48:19
Maybe you could argue a little bit disinflationary for core inflation because nominal wages are growing 3.5% based on the ECI Employment Cost index. Whereas you know that that level that’s consistent with wages being neutral for inflation closer to 4% maybe 4 ½%. So you know, I don’t think the labor market is a big problem for the Fed. When it comes to core inflation the problematic things are going to be outside their control. Any lingering supply chain issues from a conflict in the Middle East pass through from past increases in energy prices. And of course, the AI build out. You’re seeing, you know, prices tied to AI and electronics. They’re rising, but monetary policy can’t affect either one of those. It’s so, you know, when the fed looks at it it’s both demand and supply.
The same old watch, wait, and pray for a better trend, Fed 00:04:33:12
And then, you know in the end they’re just going to most likely want to sit on their hands and kind of hopefully ride this out for the next several months.
US is a complicated economy 00:05:14:09
I mean, what do we make our lives so much easier if there’s like one golden statistic in economics, but there is, you’ve got to look at everything. And, you know, the US economy, it’s massive and it’s a big onion. You got to pull back all the different layers of the onion’s layers to see what’s really going on, identify where the fissures and the fault lines are, where the strengths are.
Downward revision to consumer spending is concerning 00:05:30:17
And typically, I mean, the consumer is the workhorse of the economy. But that downward revision to consumer spending in the first three months of the year, I mean, it’s concerning, but we don’t want to overreact to a single quarter or even just a few months of data. I think the consumer benefited in the first half of this year from very large tax refunds, like really cushion the blow to consumer spending from higher gasoline prices.
Higher gas prices leach spending power from consumers 00:05:56:11
To kind of put things into context, every penny increase in gasoline prices reduces consumer spending by roughly 1 to $1.5 billion over the course of a year. So that’s a big chunk of spending that hits the consumer. I think the consumer overall is under some pressure. I don’t think this year is going to be a gangbusters year when it comes to consumer spending.
Falling savings rate is a bad sign 00:06:18:14
You can see it in the savings rate that’s been trending lower for probably 12 to 18 months now. So the consumer is dipping into their savings to finance some of their consumption. So I don’t think in the second half of this year, you know, even if we get a little bit better news on the inflation front - lower gasoline prices - that the consumer is going to be taking off and spending hand over fist.
Taylor rule does not yet call for a rate hike 00:07:45:12
I think the core inflation would have to accelerate from this point forward. If you look at various versions of the Taylor rule, which I mean, the Fed doesn’t set policy based on Taylor rules, but it’s a good rule of thumb. You would have to get inflation closer, core inflation closer to 4% to justify a rate hike. Or you guys see the job market really tighten from this point.
Divided Fed likely means no policy change 00:08:04:19
Going forward, I think the odds of either one of them coming to fruition are pretty low. And Taylor rules are helpful. There are Guideposts, but they don’t capture the dynamics within the Federal Reserve. And we have a very divided Fed. And typically when you have a divided Fed like this, it’s hard to move the committee in one direction or the other, either bringing those, you know, towards being in the camp of raising interest rates or vice versa, bringing those that are in camp of raising interest rates to cutting.
Next move will be a cut but farther into next year 00:08:33:22
So I think in the end, the policy is just they’re going to sit tight through the rest of this year. In fact, we’re pushing out the timing of our next rate cut from December of this year to the second half of of 2027, because the Fed is just very, very divided. They’re going to let the data speak. And again, in the end they’re going to want to be patient.
The greater risk right now might be Fed getting too tight too soon 00:08:51:08
And I think that’s most likely the best approach because you know we’re looking and doing different simulations either using our global economic model or even the Fed’s model. A couple of rate hikes like the markets betting on. That’s really not going to make a huge difference on the inflation front. So the risk of a policy error of tightening too soon or overdoing it and pushing the labor market to be, you know, increasingly weaker, I think is a risk that the fed is unwilling to take.
So, we are back to wait and see 00:10:08:12
Because I think you pretty much laid out the reasons why they can just wait, see, and just be very patient. And gradually over the next couple of years, let inflation come down. And that’s the question that remains, isn’t it. If it will.
Inflation has been persistent for a variety of reasons 00:10:20:23 -
And that’s the big question mark. I mean maybe there’s a little hope in that. But you know, looking at the dynamics of the, of inflation, you know, and economists we’ve been scarred by the last several years. Typically a lot of humility is needed in forecasting inflation just given all the more frequent and adverse supply shocks. And that’s causing inflation to be more persistent than what we would anticipate in the past.
Fed will talk the talk and try to get markets to walk the walk 00:10:44:15
I think there’s a little bit of truth in everything. I think you just laid out there. I think the Fed, in the end, there could be a little bit of game theory going on here. They’re going to want to talk the talk, but not walk the walk, so they can let financial market conditions actually do some of the work for them.
Expect continued hawkish Fed rhetoric 00:10:58:11
So I wouldn’t be too surprised if, you know, they continue to strike a hawkish tone, let financial market conditions tighten, slow the economy a little bit, and that kind of takes the pressure off them to actually raise interest rates. So the Fed may be trying to buy itself time by sounding a little bit more hawkish. But when it comes to Warsh we’re getting, a little bit of every Warsh that people anticipated.
Policy steps are unclear but Warsh will reform the Fed 00:11:21:07
You got a little bit of the political dove in worship post meeting presser. You got inherently he’s a hawk. And that kind of rang true when he put a lot of attention on getting inflation back down to the 2% target. Not a lot of attention on the other side of the dual mandate, which is full employment. But I think the one thing that was crystal clear from Warsh’s press conferences, he’s a reformer.
Many dimensions to reform 00:11:45:04
And I think we got to see, you know, what, these changes to the Fed, there’s a lot of committees out, you know, that have been created, what they bring to the table and any changes that the Fed is making to their communication strategy, to their balance sheet policy, to what inflation measures they’re looking at.
Fed credibility is still fine 00:12:03:24
I think the Fed’s credibility is fine. If you look at five year, five year, Forward market based measures, inflation expectations, they’re well anchored. That’s people putting their money where their mouth is. So unless they become dislodged, I think the Fed’s credibility is still intact.
Another couple of years over target with inflation…00:13:24:21
<Warsh> is going to be sort of channeling his inner Greenspan, and I think he wants to get inflation back down to the 2% target. The question is how quickly does he want to get it? They’re getting it there by the end of next year I think is unrealistic. But over the next few years we could see inflation get back down to the Fed’s target without them doing a lot of heavy lifting, meaning that raising rates a couple of times I think is most likely not necessary.
So what is Warsh’s reaction function? 00:13:52:09
But of course they have to be nimble. And I think that’s one thing that Warsh is going to do is that he’s not going to paint the Fed into a corner. Historically, the Fed doesn’t like to commit to, you know, a policy one direction or the other. But you really I think one challenge for Warsh is kind of how the Fed’s reaction function is. Are they increasingly concerned about inflation versus what happens when the labor market begins to soften? Does that do they show a little bit of a pivot there. So this communication is important because you’re going to see the two-year Treasury yield would be higher than it would have otherwise been because of a lot of guesswork. I mean, Fed watching is a lot more fun now because you really need to read the tea leaves accurately to get an assessment of where monetary policy is headed, not only over the next 12 months, but over the next 18 to 2 years.
Greenspan also had a tight-lipped strategy 00:14:53:20
I mean, don’t you think? I mean, Greenspan said a lot of stuff, a lot of things without really saying anything when it comes to monetary policy. So, you know, he was an architect in that, you know, he would answer all the questions, but not really, you know, play their hand to, to front run the rest of the FOMC. And I think that’s what he’s going to kind of, you know, take a playbook out of <Greenspan>.
Productivity pick-up is real and in gear 00:16:00:13
Productivity is definitely accelerated. I mean, productivity is strong. You know, I don’t think we want to describe it as booming. I mean, relative to what, you know, trend productivity, which is roughly half a point before the pandemic. You know, that trend today of two is very, very impressive. But historically, you know, proactivity growth has been stronger. I think it’s very encouraging to see productivity growth accelerate over the last several years.
The AI productivity impact still lies ahead 00:16:24:05
None of that has anything to do with AI. It’s attributed to a very tight labor market, past investment in research and development, which, you know, leads productivity by a couple of years. Improvements in dynamism in the economy. Business formations have gone through the roof. All that is generating the productivity gains that we’re seeing today, the productivity growth that we’re anticipating in 2028-29 from AI, if that’s going to help be disinflationary.
AI has two steps the first one is inflationary 00:16:49:17
But in the near term, AI is inflationary. And then the stronger growth that we get down the road will be disinflationary from an AI perspective. But the concern is that you don’t want to set monetary policy in anticipation that you’re going to get these productivity gains because it’s very, very difficult. Going back to Greenspan, you famously said, you know, it’s very difficult to gauge technological change, and it’s just going to show up in the economic data. We could be having this discussion in 2020, 28, 29. We’ll see all the productivity gains around us, but it won’t be in the data. And that’s a challenge that I think the Fed is going to be staring down.
Some Fed – White House tensions ahead 00:18:16:11
…there is going to most likely be some tensions brewing over the next couple of years between, you know, the white House and the Federal Reserve. But it really boils down to whether or not markets start to view the Fed as being politicized, which I don’t think there’s a high likelihood of that coming to fruition. So the White House can say, you know, and kind of push their, their, their goals or desires for monetary policy, but the Fed’s going to ultimately do what’s in the best interest to get inflation back down to their target and keep the economy close to full employment. And I don’t think we’re going to see, you know, some drama here and there. But just like under Fed Chair Powell I think the Fed’s going to remain independent.
Fed to be more reactionary 00:19:39:19
Yeah. I think if you’re waiting on that major signal from the fed, you’re going to be waiting a long time. This this is going to be a Fed that’s going to be more reactionary, even though they want to be more forward-looking. I mean, the changes to the communication strategy, I mean, their post meeting statement is now essentially a tweet.
The Dots could go away 00:19:55:07
It’s very short. I know I could see them backing off the dot, the so-called dot plot, which, you know, I think you can argue one way or the other if it’s been constructive or not. But this this Fed is really going to let the incoming data speak very similar to what Powell always preached. Let’s see what the data says.
The Fed will watch data and market reactions 00:20:12:00
And that’s, I think, just going to continue to factor into the market’s reactions. But markets are investors are fickle bunch. You know their sentiment can swing quite wildly. And one thing we try to do is always separate the signal from the noise and kind of, you know, only make changes to our Fed forecast when, you know, we realize the facts have changed, therefore your forecast has changed. And that that’s underpinning our rationale for our recent forecast revision.
