Fed Faces a Big Risk, But It’s Not the One Many Think

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%.