All eyes this week will be on the release of the US consumer price index for August on Wednesday, especially after the sharp reduction in inflation from 9.1% in June 2022 to just more than 3% in July. Markets are looking for the CPI prints in the coming months to solidify the return of inflation closer to the Federal Reserve’s target of 2%, thereby clearing the way for the world’s most powerful central bank to translate this month’s highly anticipated pause in interest-rate increases into the end of the hiking cycle and to cut rates starting as early as the start of next year. The reality of this “last mile” in the current inflation battle may prove, unfortunately, to be more complicated.
In simplified terms, the strong disinflation of 2023 has been led by the goods sector with certain items, such as energy, experiencing sharp outright price declines. Its continuation is premised on the more stubborn items, such as rent, coming down and, more generally, durably subdued core price dynamics re-anchoring a low and stable inflation environment as better-behaved services join the disinflation of goods.
Under the best-case scenario, the existing level of Fed interest rates would become more restrictive as inflation declines further and as the central bank continues to reduce its balance sheet. The Fed would cut interest rates and, with the economy having surprised on the upside, the victory over inflation would come with little cost to either growth or financial stability. And while there would be no meaningful offset to the reduction in purchasing power and living standards that has hit the poorest particularly hard since 2021, this bout of high unanticipated inflation would have had the advantage of reducing some debt burdens, at least temporarily.
Count me among those strongly hoping for this scenario to play out and for the poorest segments of society to improve their living standards. Having said that, I worry that the process may not be as smooth and as timely as markets imply. It may also require policy measures elsewhere, including better safety nets.
The recent sharp increase in the price of oil and some food items threatens to seriously diminish what has been until now a very helpful and strong disinflationary impulse from the goods sector. Combine this with base effects becoming a headwind, and the economy may well experience an uptick in the widely reported annual headline inflation number in the next few months.
This is not the only possible hiccup, especially as the cooperation of core inflation is far from guaranteed. In addition to a pickup in input prices for certain goods, recent data suggest that services disinflation may end up being mild at best and ineffective at worst. This would come when a still-tight labor market and greater bargaining power for workers are countering a further erosion in real wages.
To be clear, the combined risk does not constitute a possible return to the elevated inflation rates of last year. Rather, it is the possibility that the process of a consistently moderating inflation rate becomes stuck in the 3%-to-4% range, consistently above the Fed’s 2% inflation target and keeping the structure of market interest rates higher for longer.
Should this materialize, the Fed would face a particularly delicate policy choice by the end of the year: either tolerate above-target inflation or increase the risk of an economic recession and financial instability by pursuing the current inflation target too zealously.
This choice is rendered even more complex by significant uncertainties regarding the design, conduct and effectiveness of monetary policy in a structurally evolving domestic and global economy. No wonder economists are far from united on what the neutral rate is, depriving monetary policy of an important North Star. There are also differences on what is most important now for the economic outlook, the rate of change in policy rates or their overall level and duration.
A changing supply side, both domestically and internationally, is also an input into a much-needed debate about what constitutes the desirable inflation rate for the economy now and in the future. Understandably, this is not a debate that the Fed wishes to entertain given that inflation has consistently overshot its target over the last two years and more, and not by a little. Yet it is a topic that more economists are thinking — and disagreeing — about.
The complexity does not end here. Economists also differ on the lagging effect of what forcefully became the Fed’s most concentrated set of rate increases in decades. Some think that the economy has already absorbed the vast part of the effects, while others believe there is still more in the pipeline. They also have difficulty modeling with conviction the economic and financial impact of the Fed’s balance sheet reduction. And all this unavoidably ends up having, or being perceived to have, a political angle when the country is about to enter a presidential election year and most are keen on better securing the political independence of the Fed after the repeated hits to its credibility, the lack of proper accountability, questions about trading activities of some Fed officials and the prominence of groupthink and other cognitive biases.
Despite the Fed’s initial misdiagnosis of the dynamics at play and slow start to take action, the inherent resilience and adaptability of the US economy and many of its institutions have enabled the central bank’s battle against inflation to go much better than many expected in terms of the important trifecta of bringing down the rate of price increases, avoiding recession and sidestepping significant financial instability. This has put the economy on a good footing to deal with the “last mile” of the battle, both in absolute terms and relative to the eurozone and the UK, where the risk of stagflation is uncomfortably high.
What is now ahead was well captured last week by Lorie Logan, the president of the Federal Reserve Bank of Dallas, who said, “I’m not yet convinced that we’ve extinguished excess inflation. … In today’s complex economic environment, returning inflation to 2% will require a carefully calibrated approach, not endless buckets of cold water.”
The design of that approach is complex and uncertain, especially as some of its basic parameters are now variables.
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