Macro Conditions Are Still Too Strong for the FOMC to Stop Its Rate Hikes
The headline 12-month inflation rate increased in August from 3.2% to 3.7%, according to this morning’s Consumer Price Index, but the more important core inflation (which excludes food and energy prices) showed a widely anticipated decline from 4.7% to 4.3%.
Investors are generally taking this as a reassuring sign that the Fed is finished raising interest rates to fight inflation. In fact, the market-implied probability that the Federal Open Market Committee (FOMC) will raise rates again at next week’s meeting sank from 8% yesterday to just 3% today, according to the CME FedWatch Tool. That’s whistling past the graveyard.
The Fed’s fight is not merely against inflation—it’s against inflationary pressures. Fed Chair Jerome H. Powell could hardly have made that point more clearly than in his August 25 Jackson Hole speech, which began with the strong statement “It is the Fed’s job to bring inflation down to our 2 percent goal, and we will do so” and ended with the equally strong statement “We will keep at it until the job is done.” Memo to investors: the Fed is not gaslighting you!
Pressure from Labor Markets
Let’s review the evidence on inflationary pressures. First, the labor market still shows a severe imbalance between the demand for and the supply of workers. There are lots of ways to see this, including the unemployment rate (still well below its noncyclical or “natural” rate) and the number of job openings (still around 50% more than the number of workers looking for a job), but perhaps the most important is simply the upward pressure on wages. The Wage Growth Tracker published by the Federal Reserve Bank of Atlanta, for example, shows that growth in the median wage averaged 5.3% during June-August. Sure, that’s down from 6.7% a year earlier, but it still represents tremendous upward pressure on overall inflation.
Pressure from Aggregate Demand
Similarly, aggregate demand and supply in the overall economy still haven’t come back into balance. A good example is the retail inventory-to-sales ratio. Retailers need to keep enough stock so they don’t miss out when customers come in looking to buy, and too low a ratio indicates that supplies are not keeping up with demand. The inventory to sales ratio went dramatically negative when supply chains crashed early in the COVID pandemic, reaching a low point of 1.1, which was 39 percentage points below its long-term median. Since then it has recovered only about halfway and remains 19 percentage points below its long-term median. In other words, the demand/supply imbalance remains significantly worse than its pre-pandemic record of -15 back in 2012.
Pressure from Inflation Dispersion
Turning to inflation itself, the Fed considers more than just the overall rate of price increase. One useful measure is the breadth of inflation (also called inflation dispersion), which reflects either the proportion of goods for which prices are increasing or the proportion of total spending that is on goods for which prices are increasing. Breadth of inflation is important because it reflects whether the broad economy—rather than just certain narrow but important sectors—is subject to inflation pressures. Breadth of inflation has actually become a piece of good news, with the fraction-of-items measure having fallen all the way to its long-term median.
(The fraction-of-spending measure remains above its long-term median, almost entirely because measured inflation for housing—the single largest segment of consumer spending—remains very high at 5.7%. As I’ve pointed out before, though, that is a misleading artifact of the way housing prices are measured; actual inflation in housing costs has essentially come down to the target 2% range, if not even lower.)
Pressure from Consumer Expectations
The final piece that contributes to ongoing inflationary pressures is expectations. If consumers and business expect inflation to remain high, then the decisions they make will tend to produce higher inflation. The median year-ahead expected inflation has come down dramatically from its high of 6.8% just over a year ago—but, at 3.6% according to the latest survey, it’s still in the higher-than-acceptable range that risks pushing actual inflation up.
Inflation Can Return from the Dead
Yes, the battle against inflation is tilting in the right direction—but we’ve seen that before. In 1974, when President Gerald Ford enlisted Americans in a fight to “Whip Inflation Now,” it worked. The year-over-year inflation rate declined sharply from 12.2% in November of that year to “just” 5.0% in December 1976. But the generals failed to keep up the fight—and inflation surged again until it reached a stupendous 14.6% in March 1980.
The idea that our time’s inflation rate has declined all the way to 3.7% (headline) or 4.3% (core) is absolutely encouraging. And it was absolutely encouraging when Dr. Loomis (Donald Pleasence) shot Michael Myers six times, sending him tumbling off the balcony, to save Laurie (Jamie Lee Curtis) in the first “Halloween” movie. Do you remember what happened next?
Chair Powell’s language is much gentler than Dr. Loomis’s actions. But when Chair Powell says, as in his Jackson Hole speech, “We are prepared to raise rates further if appropriate, and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective,” we would do best to remember the threat that he and the other FOMC participants are trying to banish. Inflation can return with the power to hurt more than just little Laurie. It’s too soon to stop raising rates.