Pessimists watching the Fed’s fight against inflation focus on the so-called “last mile” problem, believing that a full return to the Fed’s 2% inflation target will require a recession and massive job losses to curb persistent price increases. History is on their side, with academic studies and other surveys concluding that the inflation levels of the past two years cannot be addressed without a recession. Leading economists expect the U.S. unemployment rate to jump from the current 3.5% to between 5% and 10%, with millions of people losing their jobs.
However, Brent Meyer, vice chairman and chief inflation watcher at the Atlanta Fed, offers a counter-argument in a new analysis, arguing that the path to the 2% inflation target may actually be smoother than many Fed officials expect. #HighInflation/Recession#
Indeed, some major price indicators have shown considerable strength. Core inflation, which excludes volatile food and energy, remained in a relatively high 4.6%-4.7% range for six months, only falling to 4.1% in June. Some policymakers saw this as evidence that the return to the Fed's goals would be slow.
However, annual headline figures can mask developing trends, and Meyer said the just-released Consumer Price Index report for July showed that the breadth of inflation is decreasing and its pace is moderating in a way that he believes is sustainable.
He added that services sector inflation minus energy and housing costs, known as the “super core,” is also an area of particular concern to the Fed and has been growing at an annual rate of just 2% over the past three months, according to his calculations.
Because the CPI index tends to rise faster than the personal consumption expenditures (PCE) measure the Fed uses to set its inflation target, that means an important area of concern for policymakers may already be below target.
If this continues, Meyer wrote, “it’s possible that we could soon be on the last mile.”
The point is that Meyer is not the only economist who thinks an inflationary trend is building.
For example, housing costs account for about a third of the CPI index and played a key role in pushing up inflation early in the pandemic, but are now expected to help curb inflation.
The performance of the single-family housing market exceeded expectations in some respects. Despite a surge in mortgage rates due to the impact of the Federal Reserve's interest rate hikes since March 2022, the house price index is still rising after a brief decline.
The 30-year fixed mortgage rate rose to more than 7% last October and fell slightly in the most recent week. However, the increase is nowhere near the double-digit growth seen in 2021, and inflation for renters has also slowed.
Because of how inflation indexes are put together, it takes time for these changes to show up in the headline data. A recent study by economists at the San Francisco Fed, which used real-time housing and rent data from companies like Zillow, predicted that housing inflation will take a “sharp turn” by the end of next year.
Instead of annual increases of as high as 8%, they estimate that the pace of housing inflation will fall to below 5% and could even turn negative, which "has important implications for the behavior of overall inflation."
The San Francisco Fed’s estimates come in two versions, both showing housing inflation hitting 0% next year, well below the 3% to 4% range Myer cited, which could help the Fed get through its inflation final mile more quickly.
Is things back to normal?
Other parts of the economy may also be stabilizing, which could be a belated validation of the Fed’s initial expectation that rising inflation in 2021 would prove “temporary.”
Supply chain pressures have eased, and as this happens, changes in commodity prices have slowed and helped to pull down overall inflation numbers.
But the path may not be entirely clear yet. Data released last Friday showed that prices paid by manufacturers rose more than expected in July, which could mean that the core PCE index could rise again in July from June's 4.1% reading.
That would be a blow to many Fed officials who want to see a steady decline in key inflation measures before pausing further rate hikes.
Quincy Krosby, chief global strategist at LPL Financial, said the recent PPI index report "provides more support for the hawkish faction of the Fed to argue for another rate hike."
But just as Fed officials were surprised when rapidly rising inflation emerged in early 2021, they have been surprised by the resilience of the economy to the rapid rate increases they engineered, and by the progress they have made on inflation without noticeably harming the job market or economic output.
Fed officials like Christopher Waller have outlined theoretical reasons why the trend could continue, arguing that pandemic-era lockdowns have created so many extreme stresses in the economy that a simple return to normalcy — such as demand for labor — could cool prices without much damage to jobs or growth.
Separately, economists at the Richmond Fed said last week that the Fed is in an “uncharted” period in history given the progress it has made in reducing inflation without a significant rise in unemployment.
Looking at past Fed rate cycles, they note that unemployment has been less volatile in each cycle since the 1980s, good news for officials hoping they can get inflation back toward target without imposing a heavy price on workers.