Why the Fed Isn’t Ready to Declare Victory on Inflation

Why the Fed Isn’t Ready to Declare Victory on Inflation
Spread the love

Officials remain concerned about whether wages and price growth can slow enough without an economic downturn.

Uncertainty over the path of inflation later this summer makes it hard to predict the Federal Reserve’s next steps following a likely quarter-percentage point increase in interest rates this week.

Some Fed policy makers and economists are concerned that the easing in inflation will be temporary. They see inflation’s slowdown as long overdue after the fading of pandemic-related shocks that pushed up rents and the prices of transportation and cars. And they worry underlying price pressures could persist, requiring the Fed to lift rates higher and hold them there for longer.

Other economists say that thinking ignores signs of current economic slowingthat will gradually subdue price pressures. They also argue inflation will slow enough to push “real” or inflation-adjusted interest rates higher in the coming months. That would provide additional monetary restraint even if this week’s rate increase is the last of the current tightening cycle.

The Fed last month held its benchmark federal-funds rate steady in a range between 5% and 5.25%, its first pause after 10 consecutive increases since March 2022, when officials raised it from near zero.

Interest-rate increases slow the economy through financial markets by lowering asset prices and raising the cost of borrowing.

Inflation cooled last month to its slowest pace in two years. The consumer-price index climbed 3% in June from a year earlier, sharply below the recent peak of 9.1% in June 2022. The index for core inflation, which excludes volatile food and energy prices, in June also posted its smallest monthly increase in more than two years.

“While things seem to be heading in the right direction with inflation, we are only at the start of a long process,” said Karen Dynan, an economist at Harvard University.

Playing catch-up on inflation-adjusted pay growth

The first camp of economists is nervous that there is too little slack and too much demand in the economy to be reasonably confident that inflation will return to the Fed’s 2% inflation target in the coming years. They don’t share investors’ recent optimism that inflation can sustainably ease without a broader economic slowdown, though they concede coming data could bolster hopes the Fed can achieve a so-called soft landing, where it contains price pressures without putting the economy in recession.

Many of these economists worry that wage growth is too strong. Without a recession, they see a tight labor market pushing up core inflation next year.

Since an overheated labor market is likely to show up first in wages, many see pay gains as a good proxy of underlying inflation pressure.

Officials are likely to see 3.5% annual wage growth as consistent with inflation between 2% and 2.5%, assuming productivity grows around 1% to 1.5% a year. 

Wages and salaries rose 5% in the January-to-March period from a year earlier, according to the Labor Department’s employment-cost index. The Fed closely watches the index because it is the most comprehensive measure of wage growth. The second-quarter figure is to be released on July 28.

Share This Post

97 Responses to "Why the Fed Isn’t Ready to Declare Victory on Inflation"

Post Comment