I have been arguing for almost a year now, here and elsewhere, that US consumer price inflation would become sticky after a period of favorable disinflation going into the end of 2023. Wednesday’s hotter-than-expected data release, the third in a row, is evidence that this scenario is indeed unfolding.
The annualized three-month measure of core inflation is now 4.5%, notably higher than the corresponding six- and 12-month measures. What has yet to be widely recognized, however, are the policy implications of this if the objective is to retain the economic exceptionalism that has served the US well so far.
At its simplified level, the continuation of favorable US disinflation required that price increases in the services sector moderate at a significantly faster rate before the outright price declines that we’ve seen in goods reversed course. This is not happening. Thus, the turn higher in the inflation metrics; and the dramatic market repricing of expected interest rate cuts by the Federal Reserve from seven at the start of 2024 to less than two today.
This repricing by traders is consistent with the view of a heavily data-dependent Fed. Policymakers, haunted by their gross mischaracterization of inflation in 2021 as transitory and memories of the monetary policy mistakes of the 1970s, will tend to be heavily influenced by backward-looking data in deciding how to get to the central bank’s 2% inflation target. This is despite a widespread recognition that their policy tools act with a lag.
More analysts now expect Fed Chair Jerome Powell to abandon his narrative of the last two months of nothing having changed in the favorable inflation picture. Instead of hoping it was about seasonal factors, they reckon he will shift to a more hawkish tone, just as he finally did in November 2021 when, in front of Congress, he retired the word transitory from the Fed’s vocabulary ahead of inflation peaking at over 9%.
That 2021 pivot was the right one, as unqualified and as late as it came. The likely forthcoming pivot is more tricky.
As I have argued for a while, the global economy is operating in a different paradigm, one of insufficiently flexible aggregate supply as opposed to the 2010s regime of insufficient aggregate demand. The inflationary consequences are more acute for the US due to its economic and financial strengths than for the other two systemically important economic regions, China and the Eurozone. Absent another Fed policy mistake, these strengths would be reflected in persistent US economic exceptionalism in 2024, including within the Group of Seven nations.
Rather than maintain a policy reaction function anchored by excessive dependence on backward-looking data, the Fed would be well advised to take this opportunity to undertake a belated pivot to a more strategic view of secular prospects. Such a pivot would recognize that the optimal medium-term inflation level for the US is closer to 3% and, as such, give policymakers the flexibility to not overreact to the latest inflation prints.
As I detailed in a column last month, this path would not involve an explicit and immediate change in the inflation target given the extent to which the Fed has overshot it in the last three years. Instead, it would be a slow progression. Specifically, the Fed “would first push out expectations on the timing of the journey to 2% and then, well down the road, transition to an inflation target based on a range, say 2-3%.”
In doing so, it earns important policy optionality while minimizing the threat of both de-anchoring inflationary expectations and further damaging its credibility.
While not without risks, such a policy approach would result in a better overall outcome for the economy and financial stability than one that sees the Fed run an excessively tight monetary policy. It would allow US economic exceptionalism to continue rather than fall victim to an unnecessary, sharp slowdown in growth in which vulnerable segments of the population lose jobs and wages after their purchasing power and savings were significantly eroded by the 2022 inflation surge. And, as argued in the previous column, it would be particularly impactful if accompanied by government measures that focus on improving labor force participation, upgrading skills, improving infrastructure, and partnering with the private sector to fuel future engines of growth in fields such as generative artificial intelligence, life sciences and green energy.
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