Inflation Is Still a Problem for the Federal Reserve to Tackle

It won’t be the first time. Fifteen years ago this month, when producer prices were soaring at nearly a 10% pace, then the fastest since 1981, I wrote “The Inflationary Fever Is About to Break.” I remember it well for the opprobrium it elicited, especially from some economists. And for what was about to happen. The Great Financial Crisis 2008-09 was beginning to stir, and would break with full force a month later with the failure of Lehman Brothers.

Unbeknown to most economists, the economy actually had fallen into a recession the previous December, and the downturn would be the most severe since the Great Depression. Price pressures dissipated rapidly.

Now, we’re in the opposite moment. The consumer price index rose just 0.2% in July for the second straight month—the smallest rises in 28 months, Goldman Sachs economists pointed out. The annualized rise in retail prices for June and July was just 1.9%, added J.P. Morgan economists, although they averred that is too short a span to declare a new trend. But the key source of comfort about inflation is that the year-over-year rise for the core CPI, which excludes food and energy prices, has decelerated markedly, to 4.7% in July from the peak of 6.6% reached in September.

If there’s any relief about inflation, average Americans aren’t feeling it. And for economists and the Fed, these latest readings may be as good as they get. Economists define inflation as the change in prices. So, if prices level off after a big rise, inflation is zero. On Main Street, however, inflation is seen as how far paychecks go. Americans’ average hourly earnings have just barely kept pace with consumer prices that soared during the pandemic, as the chart here shows.

No wonder that a new Reuters/Ipsos poll released this past week found 49% of Americans said inflation or increasing costs are the most important issues facing the nation—despite the sharp slowing in the rate of price increases. Some 60%—and one-third of Democrats—also disapproved of President Joe Biden’s handling of inflation, the survey found, despite the sharp deceleration in measures such as the CPI.

Inflation expectations did edge down in the latest University of Michigan consumer sentiment survey, out on Friday. Inflation was anticipated to run at 3.3% in the coming 12 months, versus 3.4% in last month’s final survey. Inflation expectations over the next five-to-10 years dipped to 3.3% in the latest survey, from 3.4% previously. This longer-run expectation was just 2.3% in February 2020 before Covid hit, note John Ryding and Conrad DeQuadros, Brean Capital economic advisers, in a client note.

But longer-term inflation expectations as expressed by the Treasury inflation-protected securities, or TIPS, market have moved higher recently. The so-called five-year, five-year forward break-even rate—the rate of inflation rate that the market sees for the second half of the coming decade—stood at 2.48% on Friday, down from a high of 2.67% in April, which in turn was the highest since 2014, according to data from the St. Louis Fed. But this measure had been running in the 2.10%-2.25% range until recently.

And that’s if you take the CPI data produced by the Bureau of Labor Statistics at face value. “Government statisticians’ sense of humor is in full display when they report an 8.1% month/month drop in airfares” for July, according to a client note from the Leuthold Group. Compared with a year earlier, the BLS reckons, airfares are down a full 19%, which is a bad joke to anyone who has paid exorbitant fares for the torture of flying recently.

What matters is what the Federal Open Market Committee thinks when it meets next, which won’t be until Sept. 19-20. By then, the panel will have two more key pieces of data, the employment report and CPI for August. Most economists and the futures markets think the FOMC will hold its federal funds target range at 5.25%-5.50%. Futures priced an 88.5% probability for no change next month, according to the CME FedWatch site as of Friday, little changed from a week earlier.

But looking ahead, markets are predicting no more hikes, and rate cuts beginning as early as May Day next year. By the end of 2024, the futures market see a fed-funds rate of 4.25%. The FOMC also sees reductions next year, but starting from a higher point and with smaller cuts. The panel’s most recent projection, from June, sees a median 5.1% policy rate by December and 4.6% by the end of 2024.

Any central bank rate cuts would be predicated on a decline in inflation. In an interview with the New York Times last week, New York Fed President John Williams posited that if inflation eased and the Fed didn’t cut, the real interest rates would rise, resulting in a more restrictive stance. But, he added, rate cuts will depend on inflation’s course in the first half of 2024, which “is still a ways off.”

Nevertheless, interest-rate futures and the Treasury market think Fed easing is all but certain. With the one-year T-bill yielding 5.36% and the two-year note yielding 4.87% Friday, the market evidently sees a one-year T-bill almost a full percentage point lower, at 4.38%, a year from now.

That’s plausible if you believe inflation is going to melt away. Alternative measures, such as the Atlanta Fed Sticky-Price CPI and the Cleveland Fed, portray “stubbornly high” readings that are closer to true inflation, according to Michael T. Lewis, who heads the Free Market advisory. As a result, Lewis sees more Fed rate hikes and no cuts.

That would go against the expectations of bond and stock bulls, both of which are counting on Fed rate-easing next year. But most Americans don’t see inflation coming down to close to the central bank’s 2% target or pre-Covid levels in the near term. They’re probably right.

Write to Randall W. Forsyth at [email protected]