U.S. economy is currently in an 'environment of accelerating disinflation,' economist says

Greg Daco, EY Chief Economist, and Michele Schneider, Marketgauge.com Chief Strategist, join Yahoo Finance Live to discuss the state of the U.S. economy, the March CPI report, and the Federal Reserve's possible future moves.

Video Transcript

GREG DACO: What we're seeing is essentially an environment of accelerating disinflation. What we are seeing in the data is that economic activity is slowing. The demand for goods and services is cooling. We're seeing housing price inflation also starting to turn.

And we have wage growth that is moderating, all the right ingredients to see lower inflation in the coming months. That will allow the Fed to step off the gas in terms of tightening monetary policy. I still would expect to see one more rate hike in May. But that will likely be the terminal Fed funds rate.

And while we're not talking about rate cuts yet, there's still a possibility that there might be rate cuts before the end of the year in this environment where inflation is slowing.

- Michele, how is the market looking at the most recent developments? Clearly we saw all three of the major averages under a bit of pressure today. But in terms of what has already been priced in, what does that look like from your perspective?

MICHELE SCHNEIDER: Well, what's so interesting right now is that there's been sort of a two-year business cycle that we can see through a 23-month moving average. And there are certain areas of the market that are above that, showing some level of expansion. Of course, the metals being probably one of the premier ones, but also semiconductors are still up there. And then others that are showing more stagnation, like a lot of the stocks and sectors within the S&P, and others that are showing contraction, which right now would be more of the retail, particularly discretionary, and, of course, the financial and the banking sector.

And so you've got this very divided market here at these different points of cycles. So when going forward, what I'm really looking for is how much more expansion or contraction we get from the areas that are just sort of sitting right there in the middle, and besides the S&P, where that would also be, say, small caps that are even weaker than the S&P 500, but NASDAQ as well. Everything is under this 23-month moving average, except for some of these other pockets that are more commodities-related.

And so what that tells me is that we could still see a trading range for quite some time, and yet still see kind of opposite from what Greg just said, inflation, particularly in areas that have to do with food and energy, which the CPI did not reflect, because a, it's lagging, and commodity prices in oil and energy have gone up since, and 2, because we have all these other insidious factors to consider, like what's happening geopolitically around the world, and with Mother Nature and drought. So, yeah, we're very mixed.

- And Greg, circling back to the Fed minutes, which I mentioned, the fact that they acknowledged some possibility of a mild recession, is there an acknowledgment in going ahead and raising rates that maybe the Fed thinks we need a mild recession to bring inflation down to their target of 2%?

GREG DACO: Yeah, I think to some extent that is the Fed communication. The Fed has been saying all along that it wants to see below-trend growth, below-trend labor market growth, in an environment that would lead to cooler inflation. The staff projections now have a mild recession in them. But if you look at the FOMC's projections, the summary of economic projections, they also in a sense show a recession.

So that's been there all along. I think the key concern right now that we have is this massive disconnect between what markets are pricing in terms of rate cuts before the end of the year, and the fact that the Fed is still communicating an intent to maintain rates at an elevated level. That type of disconnect between Fed pricing and what markets are anticipating can lead to significant repricing in the coming months.

As I've said all along, I do expect to see inflation accelerate in terms of the disinflationary trend. That is going to pick up momentum over the coming months. We've talked about this in the past. I do expect to see headline CPI with a 2% handle before the end of this year. And we're going to see that trend accelerate and pick up, which will allow the Fed to step off the gas in terms of tightening monetary policy.

- Michele, where do you see the CPI inflation level by the end of the year?

GREG DACO: I wouldn't be surprised to see in the fourth-- oh, sorry.

- Michele, go ahead.

MICHELE SCHNEIDER: I'm sorry. No, no, listen, I think that's an incredibly optimistic take. But I don't agree that CPI is going to decrease that much. Actually even statistically when you have inflation rates over 6%, it could take years for it to actually correct. And I think the mild recession term is a disguise for what really is going on, which is stagflation, which of course would mean lower labor force, which is very possible, and some declining numbers as we're seeing in the CPI currently, but also means that there are going to be areas of inflation that are still going to continue to rise.

And we're seeing that. If you look at sugar, coffee, oil today, precious metals, copper, none of these areas are starting to decline. If anything, they have found a base and they are starting to pick up. And that suggests to me that the raw material aspect of the universe right now still has issues, whether it's supply chain issues, mother nature issues, war issues, social unrest issues.

And that to me is really where my focus is. And those are the areas that are in expansion while the rest of the market, for the most part, sits and waits.

- And we just--

MICHELE SCHNEIDER: But I don't think-- I don't, sorry, I just want to say one last thing, and that is I think the Fed has a really tough decision to make here. And that's why they're speaking both sides.

- No question. We just showed energy prices, Michele, and that's what I wanted to get your thoughts on. One, we have a winner for us in the energy sector, and also another one in staples. Why Target, if you could explain those two?

MICHELE SCHNEIDER: Well, I think we are seeing a little bit of a switch back into the staple area. I mean, Target is one, just even from a consumer instinct, been going to Target stores and talking to people who go to Target stores around the country. And they're actually relatively robust in terms of sales right now, but people are buying things, obviously, at cheaper cost, and things that they need.

Also Target's kind of an interesting store because it's more inclusive. And that's a trend, by the way, it's not a huge trend-- but inclusivity in terms of fashion is something that's out there. But other staples to look at, Procter & Gamble, PepsiCo, Conagra Brands.

These things are actually also on chart-wise looking very strong. So I would think that that could continue to hold up and possibly outperform as we go forward.

- All right, Michele Schneider and Greg Daco, and Greg, I still think I'm looking good for that steak dinner on two handle by the end of the year. But still some time for you to win this bet. Good to see you both. Thank you.