How the Fed Should Talk About Inflation

US inflation slowed again in December — with luck, bringing forward the point at which the Federal Reserve can safely stop raising interest rates. It’s good news, but it complicates one crucial aspect of the Fed’s job as the gap between what the central bank says it will do and what financial markets think it will do threatens to get wider.

Consumer prices actually fell last month, by 0.1%, compared with the month before, thanks mainly to lower energy costs. On a 12-month basis, inflation slowed from 7.1% in November to 6.5%. Core inflation, excluding food and energy, fell to 5.7%, the lowest in more than a year. Most notably, the prices of so-called core services, which the Fed is known to watch closely as a measure of underlying inflation, are also rising more slowly than before.

None of this should come as a great surprise. A sharp decline from earlier peaks in 12-month inflation rates was baked into the numbers because of the sudden acceleration of prices early last year, and there’s likely more to come. The question is whether, without further increases in interest rates, this trend would eventually push inflation all the way back down to the Fed’s target of 2%.

As things stand, that still looks unlikely. With unemployment at just 3.5% and employers struggling to fill vacancies, the labor market is still exceptionally tight. Wage inflation appears to be slowing but is still substantially higher than before the pandemic. Reconciling a red-hot labor market and strong consumer demand with 2% inflation would be quite a feat. It certainly isn’t to be counted on.

Granted, slowing inflation tightens monetary policy in its own right by raising real (inflation-adjusted) interest rates. The Fed will need to take this into account. Nonetheless, recent statements by Chair Jerome Powell and other officials affirming the need to raise the policy rate by at least another half point seem warranted. Growth in wages has to subside more convincingly before tightening can safely stop and go into reverse. The new data do support a slower pace of rate increases — many forecasters expect the next one to be 25 basis points, not 50 — but it’s still too soon to declare this battle won.