The Most Recent Inflation Trend Matters The Most

On Wednesday, the Fed officially raised its rate target by three quarters of a percentage point, increasing the rate it pays on reserve balances to 3.15 percent (up from 2.4 percent in July). Predictably, most of the news reports sound terribly bleak.

One headline proclaimed that the Fed lifted rates “to curb runaway inflation.” Another acknowledged “the move was unsurprising,” but still blamed the Fed for the day’s stock market decline because Chair Powell “strongly suggested that more big rate hikes are coming.” According to NPR:

The Federal Reserve ordered another super-sized jump in interest rates today, and signaled that additional rate hikes are likely in the coming months, as it tries to put the brakes on runaway prices.

Given Powell’s widely covered August promise (delivered almost one month to the day) to “keep at it until the job is done,” it’s pretty hard to see how anything in this week’s announcement was much of a surprise. Still, the bigger problem with these kinds of reports is how they’re characterizing inflation and rate increases.

First, it is true that the price level is much higher than it was prior to the pandemic. However, journalists have been displaying a stubborn tendency to focus on the year-over-year inflation changes while ignoring the month-to-month rate increases.

The month-to-month changes are the ones that give a more accurate picture of where inflation is currently going. The year-to-year changes are telling us more about how the price level behaved last year. Yes, the price level could spike again in the future, but that’s not the point.

Because of the price level spike that already occurred, the year-to-year changes will remain high even when inflation starts leveling off. In this case, very high.

But it’s good that the growth in the price level (especially, but not exclusively, as measured by the CPI) seems to have calmed down. If that trend continues, it means that inflation has slowed even though the year-to-year rate changes remain elevated.

As the nearby chart shows, if the month-to-month rate remains at 0.1 percent through August 2023, the year-to-year inflation rate won’t drop below three percent until May 2023. Put differently, the price level (the gray line on the chart) can remain flat for almost one full year, but the year-to-year changes will remain above average because the initial spike was so high.

One key takeaway here is that the Fed does not have to drive the price level back down to the pre-pandemic level for inflation to return to the neighborhood of a two percent target.

Luckily, the Fed is familiar with this concept. It also understands that if it ignores this concept and, instead, tightens monetary policy so much that it drives the price level back to the pre-pandemic level, it is very likely to cause a recession. There’s no compelling reason to try that route especially since, over time, income growth tends to keep up with inflation. (That’s not to say the current episode is painless, only that a massive deflation would be worse.)

The second recurring problem is how so many journalists characterize the rate increases themselves.

It’s very hard to tell just from reading the news, but the Fed can’t make “interest rates” whatever they want. In general, if the Fed tries to push rates above their equilibrium, the result will be the opposite: falling rates.

If, for instance, the Fed tries to maintain unnaturally high interest rates (at a level above the natural rate), it will lead to excessively tight monetary policy. That is, credit flows will dry up relative to what market conditions would otherwise produce.

As this excessively tight policy takes hold, everything else constant, total borrowing, overall spending, and the price level will fall. The drop in the demand for credit will lead to a lower federal funds rate because lenders will have to drop rates to attract customers. (The same mechanisms apply if we focus, instead, on the wholesale funding side).

More broadly, interest rates are determined by all kinds of global factors, from investors’ expectations to consumers’ saving habits. The Fed doesn’t control those factors.

A great example is the beginning of the Fed’s current tightening cycle. As I pointed out in March:

While everyone was busy arguing about how aggressively the Fed’s Open Market Committee should act, short-term interest rates were busy forcing the committee’s hand. The 3-month Treasury was 0.05 percent in November but ended February at 0.33 percent. From February 1 to March 15, the rate on overnight nonfinancial commercial paper basically doubled, rising from 0.16 percent to 0.33 percent. The one-week financial commercial paper rate followed nearly the same path.

The Fed raised its target rate in March, after these market rates increased.

It’s very easy to get hung up on what the Fed says about where it thinks rates will have to be in the future, but that’s more important if you’re a bond trader. The rest of us should be skeptical of those projections because they are based on changing conditions which are also hard to predict.

Remember, in December 2021 the Fed’s median forecast for the 2022 federal funds rate was 0.9 percent, and for 2022 real GDP growth it was 4 percent. In August, those median forecasts were 4.4 percent for the federal funds rate and just 0.2 percent for GDP.

I’m not pointing out these shifts because they reflect how bad the Fed is at forecasting. Nobody is particularly good at forecasting long-term economic data, especially when conditions are abnormal.

The point is that Fed does not have tight control over rates or the broader economy. If it did, it wouldn’t have had to adjust its forecasts so much, and there would be no reason to worry about whether the U.S. is heading for a recession.

All that said, there’s a good case to be made for taking a deep breath and relaxing.

The Fed has raised its target rate by three-quarters of a percentage point three consecutive times, and the most recent month-to-month price level changes suggest inflation is slowing. While the housing market is cooling, as expected with higher rates, broad financial conditions do not appear extremely tight, and total commercial and industrial lending have continued to grow.

So, the Fed could very well stay its current course, without the “super-sized” rate hikes that are likely to induce a recession. If inflation expectations stay anchored–and there are indications that the Fed has succeeded on this front–the Fed won’t have to go crazy.

Maybe the best part is that journalists can help the Fed on the expectations front. All they have to do is start giving more weight to the recent direction of the price level and stop expecting the Fed to do more than it really can.