Back in March, I wrote a Chart of the Week post outlining what was to come for the Federal Reserve (Fed) in its fight against persistently high inflation. With the dust still settling from last week’s Federal Open Market Committee (FOMC) meeting, where the Fed raised rates by 75 basis points (bps) for the third consecutive time, it feels like a good time to refresh the outlook set forth in that earlier post. In today’s Chart of the Week, I lay out both the challenges and reasons for optimism for the Fed.
With the Fed now well into its cycle of monetary tightening, there are a few reasons to be optimistic about the way things are going. At the time of my last writing, the war in Ukraine had just begun, leading to skyrocketing energy prices. Over the course of the past few months, we have seen energy prices beginning to ease. This has resulted in some downward momentum in headline inflation.
Also providing some relief on the supply side, there has been evidence that supply chain bottlenecks have improved over the last six months. A surging dollar should also provide some inflation relief by making imports cheaper. Most importantly, as evidenced by 5y5y forward inflation rates, inflation expectations are remaining anchored around 2.5%. As long as this continues, the market is lending credibility to the notion that it believes the Fed will do its job.
Despite the reasons for optimism, several challenges remain in the fight against high inflation. Some of them are new while others have persisted since I last wrote on this topic. One hallmark of this cycle has been the extremely hot labor market. This has resulted in upward pressure on inflation due to wage increases, as well as the risk of a wage-price spiral occurring.
Over the last few months, the labor market has shown no signs of slowing. Data has consistently shown increasing nonfarm payrolls and a sticky unemployment rate. A new development lending more credence to the possibility of a wage-price spiral is the prevalence of companies stating in earnings reports that they have been able to pass increased costs along to consumers.
The biggest new development has been on the core inflation front. Core inflation strips out volatile food and energy prices, and more closely reflects the aspects that can be controlled through the Fed tightening financial conditions. Encouragingly, Core Consumer Price Index (CPI) decreased earlier this year before recording a few unchanged prints. However, in August, Core CPI began to increase again, setting off new alarm bells. This increase was led by the price of services, with the cost of shelter leading the way.
In light of these challenges, the Fed has become increasingly hawkish over the past few months. The pace of rate hikes has been very steep, with the federal funds rate increasing by 3% since my last post. The latest Summary of Economic Projections, which was issued at the September FOMC meeting, also tells a different story from earlier this year. The Fed now sees the federal funds rate for 2022 and 2023 as 100 bps higher than it did in June. It also expects to hold rates steady throughout 2023, not projecting any rate cuts until 2024.
Additionally, growth has been revised down while unemployment has been revised up. Recent messaging has also frequently referenced the necessity of some economic pain, while the talk of a “soft landing” from a few months ago has disappeared. The message is clear — price stability is crucial and the Fed is going to do what it takes to get there.
There have been some key developments in the fight against high inflation since I last wrote about this topic. While there are reasons for optimism, these seem to be outweighed by both new and persistent challenges. In response, the Fed has been forced to become increasingly hawkish at a rapid pace. The new expectation is that rates will need to be higher for longer in order to combat inflation.
Encouragingly for the Fed, it still seems that forward-looking inflation expectations are anchored around its 2.5% target. In order to keep this credibility, the messaging will most likely remain that inflation is the most important issue the Fed is facing. The question that remains is — how tight will financial conditions need to become?
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