“For me, a big, big party – and I mean, this is really as fun as it gets – is a really good inflation report” Jerome Powell is reported to have responded at a recent college fireside chat, when asked what “fun” looks like for a Federal Reserve chair. The Fed chair is truly staying on message!
The Fed did indeed get some good news on inflation recently, in addition to the Labor Department’s consumer price index, which showed price increases slowing in October. Price growth as measured by the personal consumption expenditures price index – the Fed’s preferred inflation gauge – was the slowest since May of this year. The 12-month inflation declined to 3% and, most notably, over the six months ending in October, core prices – which exclude the more volatile energy and food prices – rose by 2.5% on a six-month annualized basis. That is down from 4.5% in April, and not that far from the central bank’s target rate.
For consumers who have been battered by a historic run-up in inflation, this is undoubtedly wonderful news, and, for the Fed, it is remarkable progress. The Fed chair, however, does not yet seem ready to declare an all-out-party; he continues to emphasize that progress must continue in order to reach the 2% objective.
Indeed, it may still be too early to declare a complete victory on inflation. The inflation has come down from the peak of 9.1% that it hit in June 2022, but it is quite possible that the Fed might still have a fight on its hands until inflation is reliably down to 2%.
To be sure, price growth is slowing down. In fact, prices on some goods are actually falling. For example, prices of durable goods, such as appliances, furniture, used cars and other long-lasting items, fell by 2.2% in October on a year-on-year basis. Falling prices on durable goods, however, may in fact be more of a “return-to-normal.” Indeed, for decades, durable-goods prices fell on average (Figure 1) due to deflationary tailwinds brought on by increasing globalization as lower barriers to trade and productivity gains helped lower costs and prices. This was before a pandemic-driven surge in consumer demand for furniture and home improvement and other such goods, supply chain disruptions, and ensuing product shortages reversed this trend and sent prices skyrocketing.
Figure 1: Yearly % Change in Durable Good Prices
As these pandemic price pressures finally ease, falling prices on durables would seem like the old times. At the same time, however, it is noteworthy that, while durable prices are still falling, the pace at which they are falling appears to have slowed down in the last three-month period ending in October from the previous three-month period ending in July. One concern is what happens going forward as the relief from pandemic price pressures disappears, but the deflationary tailwinds are no longer there.
In contrast, prices of services continue to increase – albeit at a slower pace, but certainly at a rate that remains stubbornly above the Fed’s target rate. The price growth on services such as healthcare, transportation and recreation not only remains elevated, but also appears to have accelerated in the last three-month period ending in October from the previous three-month period ending in July. Perhaps, most concerning, however, is the price of housing services such as home rental, which increased by 5.8% in October in a year-on-year basis. Unless mortgage rates come down significantly and housing inventory improves dramatically, it is difficult to see how housing inflation can come down to a level that is closer to what Fed wants to see. That is perhaps why the Fed chair often emphasizes core services index excluding housing as his focus. Nevertheless, it remains to be seen if the current softening in the labor market and wage growth will be sufficient to slow down the services inflation, even excluding housing.
Figure 2: Price Indexes for PCE by Major Type of Product
Choose Your Poison: Recession or Inflation
I recently read about an old study by Nobel laureate Robert Shiller examining how much people disliked inflation and why. The findings are interesting: Asking respondents from the U.S., Germany and Brazil, he found that people cared more about low inflation than worry about recessions. The reason, he also found out, is that people think inflation is something done to them by government or companies, whereas if wages rise (also inflationary), that is something they earned.
With the economy showing signs of strain, labor market softening and wage growth moderating, the Fed chair will now face the possibility of being accused of reacting too slowly to signs that the inflation crisis is over, after having been widely criticized for misjudging inflation’s pandemic trajectory. The challenge will be to ensure persistence in keeping monetary policy tight in the face of weaker employment and activity growth and pressure to declare victory prematurely. The Fed should not be deterred from keeping interest rates elevated – though that may prove extra challenging as we head toward next year’s presidential elections.
We (Still) Need to Talk About Inflation