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The Fed Finally Realized Progress on Inflation Has Stalled

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Inflation Also Rises: A Fed Story

The Federal Reserve admitted yesterday that progress on inflation has stalled and that it will take longer for the Fed to achieve the confidence it needs to cut interest rates.

The Fed’s official statement was expanded to include the statement that “in recent months, there has been a lack of further progress toward the Committee’s 2 percent inflation objective.” In the press conference, Federal Reserve Chairman Jerome Powell was even more explicit, going so far as to state that “further progress in bringing [inflation] down is not assured and the path forward is certain.”

It’s been quite a roller-coaster for the Fed. Last summer, Fed officials still believed that monetary policy was not sufficiently restrictive. At the June meeting, the Fed kept its benchmark federal funds rate unchanged at the range of five percent to 5.25 percent, but the median projection showed officials expected more hikes last year.

The Fed hiked again in July. That turned out to be the final hike of the cycle, although Fed officials did not know that at the time. There were no projections released at that meeting, but the September meeting revealed Fed officials still expected one more hike. What’s more, the September projections showed officials expected fewer cuts in the following year, raising the end of 2024 median projection from 4.6 percent (which was one hundred basis points lower than the end of 2023 projection) to 5.1 percent.

The next set of projections embodied the pivot of the Fed away from hiking. Fed acknowledged that they had concluded hiking back at the July meeting and brought the year-end projection for 2024 back down to 4.6 percent, the equivalent of three hikes for the following year.

The False Dawn of Disinflation

It’s easy to see why the Fed became complacent about inflation at the end of last year. The personal consumption expenditure (PCE) price index, which the Fed uses as its official gauge of price stability, ran at or below the Fed’s target in seven months last year. In the final three months, the inflation prints coming out of the Commerce Department’s Bureau of Economic Analysis looked very promising. In October, the annualized increase was just 0.42 percent. That was followed by a decline in November of 0.85 percent (later revised down to just half that) and a 1.5 percent pace in December.

Core inflation was running a little hotter but still looked promising. October’s annualized gain appeared to be 1.8 percent (since revised to 1.7 percent), November’s came in at 0.7 percent (later revised up to one percent), and December’s reading was 1.8 percent. Median PCE inflation also looked good, registering a month-over-month gain of 0.3 percent in October, 0.2 percent in November, and 0.1 percent in December.

Folks like New York Times columnist Paul Krugman declared that the war against inflation had been won and “team transitory” had been right all along. Many market watchers began warning that the Fed would risk triggering an unnecessary recession if they did not start cutting interest rates pronto.

It wasn’t just the pundits who thought inflation had been whipped. The market did also. By the end of last year, the swaps market was pricing in six or seven cuts in 2024, more than twice what the Fed was projecting. Even the more cautious analysts figured the Fed would likely cut every other meeting, which would be four cuts.

It became fashionable for Wall Street analysts to talk about real rates, interest rates minus the rate of inflation. They pointed out that the decline of inflation meant that the real rate was increasing, so the Fed’s policy was tightening even while it left the nominal rate alone. Just to keep the real rate steady, they argued, the Fed would have to cut several times this year.

The warning signs were easy to spot, but apparently even easier to ignore. Economic growth, for example, was extraordinarily high in the second half of last year, suggesting that monetary policy was not as restrictive as Fed officials thought. The rate of increase of the personal consumption expenditure price index for services was actually accelerating, rising at a 2.3 percent annual pace in October, 3.1 percent in November, and 3.7 percent in December. In other words, all of the disinflation was coming from the goods side, largely as a result of improved supply chains rather than dampened demand.

What Will It Take for the Fed to Pivot Again?

Fed officials deserve some credit for not getting caught up in the Victory Over Inflation hype. The January statement made it clear that cuts were not imminent. The Fed said that it would need several more months of good inflation data before it would gain the confidence that inflation was sustainably coming down to two percent.

It got the opposite in the first quarter of this year. Inflation came storming back in January and only cooled a bit in February and March. The Fed’s fear that the disinflation of 2023 could prove transitory seemed a very real possibility.

Fed officials still think the disinflationary trend will return. Powell said Wednesday that the appropriate policy response is to keep the policy rate where it is and wait for more data. He added, however, that it would now take an even longer stretch of good inflation prints to convince officials that the time is right for cuts.

Federal Reserve Chair Chair Jerome Powell speaks at the press conference at end of the Federal Open Market Committee (FOMC) meeting, in Washington, DC, on May 1, 2024. (SAUL LOEB/AFP via Getty Images)

The Fed did not release a new set of projections. We will not see those until the June meeting. But it is clear that the median forecast would no longer be for three rate cuts this year. It’s probably down to two or maybe just one.

The wait-and-see approach may be prudent, but it is not without risks. Just as real rates rose with last year’s decline in inflation, this year’s acceleration means that real rates are falling. Monetary policy is loosening even while the Fed leaves rates unchanged.

What will it take for the Fed to change its overarching view that monetary policy is sufficiently restrictive and inflation is on a downward trend? Another quarter of hot inflation will probably do the trick. That means, however, that a Fed pivot back to hiking probably will not occur until the September meeting at the earliest.

But anyone watching the data should be able to predict the pivot earlier than that. If inflation continues to run above target in April, May, and June, the Fed will likely take cuts off the table. If it runs as hot as it did in January, the Fed will start preparing the market for a hike.

Powell said Wednesday he thinks a hike is unlikely. The data over the next few months may change that view.

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