A hawkish holiday cut

Bottom line

At its last policy-setting meeting of the year, the Federal Reserve officials cut interest rates by an expected quarter point, bringing the upper band of the fed funds target range to 4.5%. In the updated Summary of Economic Projections (SEP), they increased their forecast for core PCE inflation from 2.2% to 2.5% in 2025 and pushed out by a year to 2027 their expectation of reaching the longer-term inflation target of 2.0%. Elsewhere in the SEP, policymakers raised their estimate for GDP growth next year from 2.0% to 2.1% and reduced the forecast for the unemployment rate from 4.4% to 4.3%. 

But due to the surge in inflation, Fed officials shocked markets by removing two of their four previously projected quarter-point interest rate cuts in 2025, shifting one to 2027. If the new expectations come to pass, it likely wouldn’t take the fed funds rate to its longer-term terminal value of 3.0% until at least 2027. Stunned investors responded, with the S&P 500 plunging, benchmark 10-year Treasury yields spiking and the volatility index nearly doubling.

Fed miscalculated It’s now clear to us that the Fed erred in cutting rates by a supersized 50 basis points in September, seemingly lulled by a then-temporary softening of inflation data and a weakening labor market. The reality is that the labor market is strong, as the initial weekly jobless claims for the December survey week dropped 9% to 220,000. Moreover, inflation is resurgent, business and consumer confidence is soaring and holiday spending is stronger than expected.

Inflation is persistent:

• Average hourly earnings rose 4.0% year-over-year (y/y) in November, and 0.4% month-over-month (m/m) (the latter annualizes to 4.8%). The Fed wants to see this metric decline to 3.0% y/y growth.
• Core PPI (wholesale inflation) has surged from 1.8% y/y in December 2023 to 3.4% in November 2024. 
• Core CPI (retail inflation) declined from 3.9% y/y in December 2023, but it has stalled around 3.2% in each of the past six months. 
• Core PCE inflation (the Fed’s preferred measure) declined from 3.0% y/y in December 2023, but has stalled in each of the past five months through November at 2.7-2.8%. The Fed forecasts that it will decline to 2.5% in 2025 and 2.2% in 2026, before falling to its 2.0% target by year-end 2027.

Solid consumer spending Retail sales on goods have rebounded over the past three months, as a return of “animal spirits,” likely election-related, has sparked a sharp increase in business and consumer confidence, particularly among high-end shoppers. 

Headline retail sales in November (which are not adjusted downward for inflation) rose by a stronger-than-expected 0.7% m/m (consensus at 0.6%), largely driven by robust auto sales in the wake of hurricanes Helene and Milton and solid on-line spending. October results were revised up a tick to a gain of 0.5%. September data (the last month of the important Back-to-School season) was also revised up a tick to a strong final increase of 0.9% m/m, resulting in an upward revision in third-quarter GDP from 2.8% to a final gain of 3.1%.

“Control” results (which strip out autos, gasoline, building materials and food service, and feed directly into the quarterly GDP report) rose by an in-line 0.4% m/m in November, compared with a modest 0.1% decline in October. September was revised up a tick to a robust final gain of 1.3% m/m.

Strong holiday spending In the first two months of the important four-month (October through January) holiday shopping season, spending has risen a combined by 3.3% y/y, much better than last year’s increase of 2.7%, the weakest season in five years. The National Retail Federation expects 2.5-3.5% sales growth during November and December this year. November spending alone surged by 3.8% y/y, so the trend is accelerating. 

Weak BTS sales reverse Over the past 30 years, holiday and Back-to-School (BTS) sales have been roughly 73% positively correlated, and personal consumption accounts for about 70% of GDP. Although BTS (June through September retail sales) rose only a paltry 2.2% y/y in 2024—the weakest spending trend in 15 years—the sharp improvement in confidence has pushed holiday spending thus far to the high end of expectations.

Confidence soaring Business and consumer confidence have surged in recent months: 

• NFIB Small Business Optimism Index rose from an 11-year low of 88.5 in March 2024 to a more than three-year high of 101.7 in November.
• University of Michigan Consumer Sentiment Index soared from an eight-month low of 66.4 in July 2024 to an eight-month high of 74.0 in December.
• Conference Board’s Consumer Confidence Index rose from a two-year low of 97.8 in June 2024 to a 16-month high of 111.7 in November.

Thanksgiving weekend tasty According to the National Retail Federation (NRF), 197 million people shopped during the five-day period from Thanksgiving Day through Cyber Monday, with 126 million people (64%) visiting physical stores. Auto-related spending surged 2.6% m/m, driven by people replacing vehicles damaged by the hurricanes. E-commerce results rose 1.8% m/m, and specialty stores selling sporting goods, books, hobby items and musical instruments rose 0.9% m/m. The NRF added that shoppers were motivated by discounts.

Solid Christmas tree sales Starting in 2003, Evercore ISI has gathered data from regional associations, farmers and retailers in the U.S. and Canada to gauge sales of Christmas trees, wreaths and garlands. If consumer confidence is high and the economy is strong, people usually spend more money on their holiday decorations. Three weeks into the four-week holiday season, the survey has posted a relatively solid 7.0% y/y sales gain, compared with weak 4.5% gains in each of the previous two years. Tall trees ranging from 9-11 feet are this year’s top sellers, suggesting that high-end consumers with larger homes are feeling flush. 

Low-end consumer remains stressed The personal savings rate, which plummeted from 32% in April 2020 to a 17-year low of 2.0% in June 2022, has now risen to 4.4% in November 2024, as strapped low-end consumers are reducing spending and amassing dry powder. In addition, credit card delinquencies have more than doubled to 3.2% over the past three years. But the top 20% of consumers disproportionately account for 40% of all consumer spending, while the bottom 40% account for only 20% of total spending.

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