Investors see recent inflation data as a green light for the Federal Reserve to trim another quarter point from the short-term interest rate. When the central bank’s policymakers meet this week, they’d be wise to say: “Not so fast.” Further cuts will probably be needed in 2025, but for now a pause makes more sense.
Consumer-price inflation rose to 2.7% in the year to November, up from 2.6% in the year to October. Stripping out food and energy prices, so-called core CPI inflation stood at 3.3% for the fourth month running. Markets greeted these numbers as largely in line with expectations — and concluded there was no need to adjust their forecast of another cut in the policy rate. But that’s the wrong test. The question isn’t whether the latest numbers were a nasty surprise, but whether inflation is on track to return to its 2% target.
Right now, that isn’t so clear. It’s possible that the decline of core inflation from its peak of nearly 7% in 2022 has stalled, with prices still rising somewhat faster than the Fed’s target. To be sure, there will be pressure pushing both ways over the coming months. Note as well that the Fed focuses mainly on the personal consumption expenditure measure of inflation, not CPI. PCE inflation is running closer to the 2% target — because it gives less weight to the cost of shelter, and rising rents have been a main factor in keeping CPI inflation up. Shelter costs have lately been slowing, which should narrow the gap between the two measures.
On the other hand, the US labor market is still tight. Unemployment is low by historical standards and, according to the latest data, real hourly earnings are 1.3% higher than a year ago. Travel costs are elevated and so are car prices. Services prices, excluding housing and energy, rose 0.3% in November — again, faster than the target requires. Overall, these numbers don’t yet suggest that the current policy rate is unduly restrictive. And, unwilling as they might be to discuss the subject, the Fed’s policymakers will be aware that President-elect Donald Trump is proposing substantial new tariffs and tax cuts, both of which will push prices higher.
The Fed is making its own job harder in the way it talks to investors. It favors both “forward guidance” and “data dependence.” The first underlines the importance of stable expectations for policy: The central bank explains its thinking so that changes in interest rates are priced in ahead of time and don’t come as a shock. Consistent with this, it publishes periodic “projections” (not “forecasts,” it vainly insists) of where its policymakers think interest rates ought to be over the coming months. Data dependence, by contrast, emphasizes uncertainty: Future interest rates will depend on the outlook for inflation, which fluctuates, and the only fixed point is the 2% target.
The Fed shifts the emphasis from time to time but generally tries to get the best of both worlds — steady expectations for interest rates combined with attention to changing information on prices. But when the two are at odds, it must choose. This week would be a good time to remind investors that “Let the data decide” comes first.
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