The Federal Reserve announced Wednesday that it would leave its short-term interest rate target unchanged at 5.25 percent to 5.5 percent. The news was not a surprise. That the Fed would remain on hold was considered a near certainty in the weeks leading up to the meeting. Nevertheless, the broader conversation about interest rate policy has shifted since the start of the year, throwing cold water on rosy predictions that the Fed would cut early and often in 2024. What has changed? In short, neither economic growth nor inflation has slowed as much as expected.

The advance estimate of first quarter real GDP growth was released last week and came in at 1.6 percent at a seasonally-adjusted annualized rate (SAAR). That was below trend and less than half the pace recorded in the fourth quarter of last year. Although a downbeat number on the face of it, the underlying details make for a more complicated story. A drawdown in inventories and an increase in the trade deficit were substantial drags on economic growth in the first quarter. Neither factor should be breezily dismissed, but at the same time real final sales to private domestic purchasers, a measure of consumer and business spending, advanced at a healthy 3.1 percent SAAR.

Although economic growth is holding up for the time being, inflation is proving not so easy to tame. The Fed’s preferred measure, the year-over-year change in the price index for core personal spending, stood at 2.8 percent in March, the same as in February and only slightly lower than in December and January. This measure of inflation has come down sharply since peaking at 5.6 percent in February 2022, but progress toward the Fed’s 2 percent target has stalled in recent months. This week’s data showing that employment costs accelerated in the first quarter only bolsters that conclusion.

What do the forecasters have to say about the road ahead? The Wall Street Journal’s Economic Forecasting Survey asks more than 70 economists from academia, financial institutions, consulting firms, and trade associations (including AFSA) about their views on the outlook. According to April’s survey, they anticipate stronger near-term economic and employment growth than when the last survey was conducted in January, and also higher inflation and interest rates.

In our view, the baseline scenario remains that the economy will dodge a recession in the next twelve months, but that economic growth will trail last year’s pace by a wide margin. Measured on a Q4/Q4 basis, real GDP is seen dropping from 3.1 percent in 2023 to only 1.4 percent in 2024 (albeit stronger than the forecast of 0.7 percent growth made in January). A decelerating economy will ultimately lead to looser labor market conditions. Payrolls will continue to expand, but at a monthly pace of only 115,000 over the next year. That would be less than half the pace of the previous 12-month period and push the unemployment rate to 4.3 percent by year-end, up from 3.8 percent in March 2024.

As for the interest rate outlook, Fed Chair Jerome Powell says the next move is not likely to be up. That leaves the question of when cuts might come. Our contribution to the WSJ survey anticipated 75 basis points of cuts between July and the end of the year. In light of the last few weeks’ developments that now seems aggressive. Following Wednesday’s meeting the CME FedWatch Tool shows financial markets are not pricing in lower rates before September.

The stresses are clearly building. The likelihood of higher-=for-longer-interest rates is growing. Although generally healthy, the labor market is probably not as strong as the top-line numbers indicate. Consumer spending growth is robust, but disposable income growth is flagging, and the personal savings rate is falling. AFSA’s inaugural Consumer Credit Conditions (C3) Index shows that consumer lenders faced deteriorating business conditions in the first quarter. Critically, the gap between the aggregate economic data and individual confidence in economic conditions is large.

This list of pressure points highlights the rising risk of downside scenarios to the baseline outlined above. One possibility is a prolonged period of stagflation, with weak-to-decreasing economic growth and stubbornly elevated inflation. Another is a boom-bust cycle where growth and inflation both accelerate, forcing (notwithstanding Chairman Powells’s guidance) a second tightening cycle and subsequent recession.