The Federal Reserve’s efforts to bring inflation under control will continue to play a major role in the economy this year, National Retail Federation Chief Economist Jack Kleinhenz said in the latest issue of the NRF Monthly Economic Review.

“With the U.S. economy’s strength resting heavily on household spending, all eyes are on the consumer—and how consumers will respond the next few months to the Federal Reserve’s ongoing efforts to tame inflation,” Kleinhenz said. “While inflation is down from its peak, it has slowed less than expected and is still an important problem that remains to be solved.”

The NRF’s monthly review indicated that January’s 3.1 percent year-over-year (YoY) inflation, as measured by the Consumer Price Index, improved from the 3.4 percent in December but “still a considerable distance” from the Fed’s target of 2 percent.

The Personal Consumption Expenditures Price Index, the Fed’s preferred measure of inflation and factors in substitutions consumers make as prices change along with a broader range of expenditures, showed inflation at 2.4 percent in January, compared to 2.6 percent in December.

Kleinhenz said a key issue is the difference between prices for services, which were up 4.9 percent YoY in January, and commodity-based prices, including retail goods, which were up only 0.1 percent for the same period, according to the CPI.

Following a surge in spending on goods while Americans were sheltering at home during the initial months of the pandemic, spending is moving back toward services. As of the fourth quarter of 2023, 65 percent of consumer spending was on services, short of 68 percent in the fourth quarter of 2019 but up from the pandemic low of 63 percent in April 2021.

Overall, consumer spending dipped in January due to a decline in spending on goods and lower prices for goods, even though there was a rise in services spending and prices for services were elevated.

“The persistent strength in services spending and inflation in the service sector strongly suggest that the Fed will likely be cautious about rate cuts,” Kleinhenz said.

Fed Chairman Jerome Powell recently said that non-housing services (health care, financial services and insurance, restaurants, and transportation) are important to watch to guide inflationary trends. Those services comprise 55 percent of the PCE index and have labor as their highest cost. Powell said services face a challenge because of the labor market, which has “very high” wages and job growth, “quite elevated” vacancies and an imbalance between supply and demand.

In January, the Fed left interest rates unchanged for the fourth straight month over about seven months. The central bank’s Federal Open Markets Committee said its employment and inflation goals “are moving into better balance,” but it would not be appropriate to reduce rates until it has gained greater confidence that inflation is moving sustainably toward 2 percent.

Kleinhenz said he expects the Fed to hold rates steady in March but then cut rates by a quarter of a percentage point either at the FOMC’s meeting at the end of April or at its June meeting. The mid-year scenario is more likely if inflation indicators remain stronger than preferred. Subsequent cuts in September and December could bring the total reduction in rates to between three-quarters of a percentage point and a full point, he said.