It Will Be a Long Time Before Inflation Is Under Control

In the past month or two, the economic outlook has shifted to the sunny side of the street, with some forecasters believing the economy may bypass the much anticipated recession and comfortably settle into a “soft landing,” a gradual slowdown of economic growth that avoids a recession. This belief has been supported by inflationary pressures that have moved down significantly from the 40-year high of last year (CPI is at 3.2% from the peak of 9.1% last year) and economic data that has remained relatively robust despite the Federal Reserve (Fed) raising the federal funds rate by 525 basis points (the unemployment rate is hovering around historic lows and consumer spending remains resilient to the higher interest rates)(charts 1 & 2).

 

Much of the optimism is based on the belief that the inflation problem has been conquered. But in reality, the decline in inflation has been driven heavily by falling energy and commodity prices. When the Fed focuses on inflation, it looks at core inflation, which takes out the food and energy components because it is deemed a more reliable gauge of future inflation. Food and energy prices tend to be very volatile; they can move up as quickly as they can move down. Fortunately for the Fed, they have been falling over the past year. As for core inflation, it hasn’t declined as much.

Furthermore, the Fed’s preferred inflation gauge is not CPI but the inflation measurement that is released with the personal spending report because it accurately reflects the spending habits of consumers. That hasn’t retreated nearly as much as CPI, falling to 4.1% from a recent high of 5.4% (chart 3). The Fed still has a long battle ahead against inflation. In June, Fed Chair Jerome Powell stated that he anticipates that core inflation will not return to the Fed’s target rate of 2.0% until 2025.

 

The magnitude of the Fed’s tightening of monetary policy in this cycle has been greater than has been seen since Paul Volcker took control of the Fed in 1979. With Volcker’s shock-and-awe approach, he famously raised the federal funds rate to 20%. The first-time rates were increased that high; the following month, they dropped 850 bps to 11.5%, and the second time at 20%; the next month, they were reduced by 450 bps to 15.5% (chart 4). The Powell Fed has taken a different approach to combating inflation. It has methodically alerted the markets of planned interest rate increases in 11 hikes. The first few increases were small, increasing to several hikes of 75 bps each and gradually tapering the size of the hikes (chart 4). 

 

The Powell approach must be different; the world is different. The financial system is far more leveraged than 40 years ago, and the uncertainty of the shock-and-awe approach would play havoc on the capital markets, increasing market volatility and the risk of a severe recession. With Powell, his approach will require the Fed to keep the funds rate higher for longer to ensure inflation gets to the target rate of 2.0%, it is sustainable and expectations for future inflation remain muted. The Powell Fed does not want to do what the Volcker Fed was forced to do, which was to cut interest rates and have inflation rebound, which forced Volcker to raise interest rates a second time to 20%.