If the Federal Reserve was hoping for some sign that inflation is subsiding, it was cruelly disabused by the latest figures for consumer prices. The headline rate fell back slightly in September, from 8.3% to 8.2%, but the more telling measure of core inflation, which excludes the cost of food and energy, reached the highest rate in 40 years, rising from 6.3% to 6.6%. The message was clear: Far from relaxing its recent pace of monetary tightening, the Fed might have to raise interest rates faster and further than expected.
The central bank’s dilemma is acute. Officials acknowledge that it was too slow to start raising interest rates as the economy bounced back from its pandemic-induced slump, and has had to play catchup in recent months as a result. Yet prices are still rising, with no turning point in sight. The Fed’s plan for future interest rates might now need to ratchet higher — further narrowing the path between persistent inflation (if it does too little) and outright recession (if it goes too far).
Last week’s data offers little reassurance that things will soon improve. The headline rate has probably peaked, but high underlying inflation is getting entrenched and spreading more widely. Although energy prices fell in September, rents were up and the price of services rose especially fast, suggesting that inflation in goods might be pushing wages higher. Gasoline prices are moving up again too. In their most recent projection of interest rates — the so-called dot plot — Fed officials indicated that the pace of interest-rate increases would slow after an expected rise in the policy rate from 3.25% to 4% next month. That schedule no longer looks plausible.
It’s tempting to think that, having fallen behind the curve at the outset, the Fed should now surprise investors in the other direction: announce an unexpectedly aggressive tightening, lead markets to expect a rapid fall in inflation, and, with that accomplished, reduce the policy rate in due course. The problem is that this approach all but guarantees at least a short-term recession. Worse, any such setback could turn very nasty. The Fed needs to worry about hitherto unsuspected fragilities in a financial system that has gotten used to year after year of virtually zero-cost credit. (Look to the UK for one such fragility — in its defined-benefit pension funds, of all places).
This makes the Fed’s preference for gradualism understandable — and, for the moment, wise. Note, as well, that its commitment to getting prices back down isn’t yet questioned. Inflation expectations haven’t surged, the labor market is beginning to cool, and wages are falling in real terms. An upward adjustment in the path of the policy rate is both expected and (unless new information tells a different story) warranted. But going further would be a risk too far.
An even worse mistake would be to make light of investors’ alarm over rising prices and to claim, as officials did last year, that higher inflation is no cause for concern, or to insist that the anti-inflation strategy is working as intended. Lately the Fed has been more willing than usual to acknowledge errors, reckon with uncertainty, and confront new data with an open mind. Honesty of that kind certainly doesn’t guarantee success — but it’s the best available option.
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