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Fed in a trust-but-verify moment as inflation falls

A person arranges groceries in El Progreso Market in the Mount Pleasant neighborhood of Washington, D.C., US, August 19, 2022. 
A person arranges groceries in El Progreso Market in the Mount Pleasant neighborhood of Washington, D.C., US, August 19, 2022.  Photo : REUTERS

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In economic projections issued after their December meeting, US Federal Reserve officials on balance saw a measure of underlying inflation ending in 2024 at 2.4 per cent, with the lowest of individual estimates at 2.3 per cent.

Economists note that it would require inflation to reaccelerate from its current six-month trend of just 1.9 per cent, something many consider unlikely given the underlying math is already leaning towards at least a few more months of slowing.

If central bankers have pencilled in three-quarters-of-a-point in interest rate cuts on the basis of December’s outlook, what happens in their next projections in March when they may well have to reduce inflation estimates another notch?

“Every member of the Federal Open Market Committee envisions and expects a reacceleration relative to the past six months,” said Luke Tilley, chief economist at Wilmington Trust. “I don’t think it is likely...The baseline is too high.”

That suddenly improved outlook for inflation has upped the possibility of a rate cut sooner than later, with Fed officials aware that by not reducing borrowing costs as inflation declines they would effectively increase the inflation-adjusted, or “real” cost of money.

But they must first convince themselves that inflation is headed back to normal.

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THE LONG VIEW

The Fed meets Tuesday and Wednesday, and officials are expected to maintain rates at between 5.25 per cent and 5.5 per cent, where they have been since July.

They must also take stock of inflation that ended 2023 in much better shape than anticipated at the start of the year, which is the main reason why lower interest rates are now under consideration.

Coming into 2023, the median policymaker projection saw overall inflation as measured by the Personal Consumption Expenditures price index at 3.1 per cent at year’s end, and the core rate excluding food and energy costs was seen at 3.5 per cent. In reality, the two came in at 2.7 per cent and 3.2 per cent, respectively, in the last quarter of the year.

But even that masks a weakening trend: Core inflation for seven months running has been below 2 per cent on an annualised basis, and that has been marching progressively lower.

The Fed does not want that to reverse, which is why policymakers have been reluctant to declare their inflation fight over and still consider some risk to cutting rates too early. But they also don’t want inflation to get too low and again become lodged below their 2 per cent target, a level central bankers globally feel doesn’t interfere with economic decision-making and guards against a deflationary drop in prices and wages that can be damaging and difficult to reverse.

The Fed struggled to hit its target until the pandemic. While the run-up in prices then was fast and painful, looked at over the long-term PCE is now only about 2.1 per cent higher than it would have been if officials had met their inflation goal consistently since adopting it in 2012.

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PERSISTENCE

The challenge is determining if the world is returning to pre-pandemic norms when 2 per cent inflation, or even a touch lower, seemed baked in, a sign of the Fed’s success in “anchoring” the pace of price increases.

Reasons exist to think things might have changed, including labour markets rendered perpetually tight by population ageing, large government deficits, and new global trade and supply frictions.

Those issues have put a premium on watching for inflation’s possible persistence. Though policymakers have discounted arguments of a difficult “last mile” on inflation, they simply reframe the issue as a matter of time: if inflation for some goods and services is proving difficult to tame, the solution they feel is maintaining the current rate for longer and lowering it more slowly, rather than hiking again.

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While some alternate inflation measures have also fallen, they tend to show less progress than the headline numbers.

An Atlanta Fed database shows comparatively high inflation for many consumer goods: the share of items for which prices are rising more than 5 per cent annually remains above the pre-pandemic level.

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That alone isn’t necessarily a problem. Policymakers distinguish inflation - a generalized increase in what they call the “price level” - from changes in relative prices that can reflect temporary gluts or shortages, innovations or product changes, or other factors that aren’t necessarily “inflationary.”

But when large enough shares of the economy experience rising prices, without offsetting low inflation or even price declines elsewhere, policymakers remain concerned.

That’s kind of the situation the Fed faces now, with overall inflation in decline but enough persistence on some fronts that they are not ready to declare victory.

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STICKY SPOTS

The biggest disappointment is housing.

Many policymakers see inflation there as likely to slow in coming months. Yet other things like insurance have kept the overall pace of price increases from falling more rapidly.

How the Fed characterises it all this week could give a clue as to when rate cuts might begin.

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One ex-policymaker who advocated early on for aggressive rate hikes to tame inflation now contends the balance has shifted towards making cuts earlier rather than waiting for more evidence and potentially having to move faster.

“Based on the data today, I think you can rationalise a quarter-point reduction, and the art is to get the communication right that it is a technical adjustment” made not to stimulate a troubled economy but to account for falling inflation in an economy that is doing well, said former St. Louis Fed President James Bullard, now dean of Purdue University’s business school. “Waiting too long might get you into a situation where the committee has to move too quickly.”

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