Has Inflation Been Solved?
So, that title is slightly clickbait. I put in the question mark to make it an accurate title because we are really standing at a fork in the road with inflation, and the right way to go from here is less clear than it has been at any other point in this inflation fight. A while back, I wrote this big inflation explainer:
I want to revisit something I said in this piece that is really relevant right now, and I want to make sure it sinks in with people. In attempting to explain the Month over Month inflation, and how it differs from the Year over Year number, I said this:
If the target is 2% YoY inflation, then any MoM inflation under 0.166666% gets toward that goal. The Federal Reserve initially said they wanted a “soft landing”. While they didn’t say exactly what a soft landing means, one reasonable way to interpret this is to target MoM inflation. So, if MoM inflation came in at under 0.3% for 6ish months and around 0.1% for another 6ish months, then YoY inflation would be pretty close to the 2% target. The problem is this obviously takes a year…
There are two problems with this: first, consumers might get impatient or might begin to expect inflation. Higher inflation expectations generally lead to higher inflation because people change their behavior when they expect inflation. This hasn’t really been a problem so far, but with core inflation rising it may become a problem. Second, political interests might get impatient. Yes, inflation was 0 in July and 0.1% in August. If we get a third consecutive month in the 0-0.1% range President Biden could accurately make the claim that “at the current trend inflation will be back down to the target 2% in less than a year”. This would suggest, accurately, that the inflation problem has been solved.
But solving the inflation problem doesn’t solve inflation.
This might not make sense, so let me explain. Most people seem to conceptualize inflation as the YoY measurement. If MoM is small that means the actual CPI or PCE indices are rising slowly—so the inflation problem is gone. But, prices would still be a good bit higher than they were a year ago. So, the YoY number would still be high until there was 12 months of this disinflation. The YoY number would keep getting marginally smaller, but it would stay high until the disinflation can be measured against itself—and that takes a year. So, people might still see inflation in the high 6% to low 7% range YoY until next summer.
Basically, this is exactly what has happened.
For the last half year or so the Month over Month inflation has been consistently low. January came in higher at 0.5%, but even with that the pattern of disinflation has held. So, I wanted to quickly provide a few graphs to visualize the point I made above about YoY inflation being a misleading measure during times of disinflation.
In this graph we have the CPI—the actual index, not the percent change—for the last five years. The grey line segment starts 12 months ago, and ends with this most recent month of inflation data (Jan, 2023). Basically, the slope of this line is the headline inflation number that we see in newspapers—6.4% for January 2023. The grey line is connecting a steep part of the blue line to a flatter part, and this makes the grey line (YoY inflation) much steeper than the most recent months of the blue line.
Now, look at this next graph, where the line segment has been moved back six months, so it starts in June 2021, and ends in June 2022. It’s quite a bit steeper because this is when inflation was running high. The June 2022 CPI rose about 8.9%, which is why the slope of that line is steeper. The grey line connects a steep part of the blue line to another steep part.
For the last graph I have taken the percent change in the index for each of the last 7 months, and just repeated it. The purpose of this is to show what will happen once we have enough months banked on the less steep line—this being disinflation. Once the grey line can start during the disinflation period, it suddenly changes the inflation outlook drastically.
Now, the slope of the grey line is much flatter, which means the headline inflation number is much lower. In this case it is something like 3.7%. That is still above the 2% target set by the fed, but the headline number gets almost cut in half once the headline number is benchmarked to the disinflation period. So, if the next six months of inflation data are exactly the same as the last six months (although there is reason to expect them to be even lower), the headline inflation number will be about 3.7%.
In the last few months a big part of the inflation number has been in services, which includes housing. There is a lot of data that shows rent prices have already come way down, but the way CPI gets measured takes a while for these rent prices to filter through. Basically, CPI doesn’t look at month to month rent prices, but at lease prices. Since most leases are longer term the Fed needs several months of new lower lease prices for the CPI to reflect the reality of what people are paying for rent each month. So, there is every reason to expect that by summer the headline inflation number will come in under the 3.7% in this third graph—perhaps close to 3%.
So, the big question is what should the Fed do now? January jobs data came in really hot—over half a million new jobs—and the CPI was half a percent higher than in December. Neither of these are the signs economists look for when they are hoping for lower inflation, but one month of data does not make a trend. These two data points could just be high anomalies that won’t repeat…or not. The thing is, it’s really hard to tell because the economy is in really good shape, so it’s hard to gauge inflation. Inflation has been going down, and a lot of things still point that direction, but disinflation isn’t something economists expect to see when the economy is doing as well as it is at the moment.
As I have explained before, I still think inflation was more or less a transitory thing that got taken advantage of by corporations who were looking to raise prices, then exacerbated by the energy and food supply shocks from Russia invading Ukraine. Because of this, I fall in with the group of economists who think the Fed should probably hit the brakes on interest rate increases. It takes at least six months for these rate hikes to really filter into the economy—some economists would argue that it takes at least a year—so we are really only now starting to see the impact of higher interest rates. If this is the case, then we aren’t sure just how much weight the rate hikes of last year have already put on the economy.
Take a look at the housing market; things are going downhill pretty quickly. I wouldn’t call it a crash, but certainly some heaviness. Housing is almost always the very first place interest rates filter to because mortgage rates are so closely tied to the federal funds rate. What happens if the rest of the economy gets as heavy as the housing market in three to six months when the interest rate filters through? If that is the case, any additional rate hikes may cause some serious damage to the economy.
At the same time, if inflation isn’t beat yet then failing to raise interest rates could put us back into another summer of high inflation. Last year, when the Fed was raising rates that was unambiguously the correct decision. Right now the correct decision isn’t so clear. If I were in charge (and thank goodness I’m not!) I’d like to see a pause on interest rate hikes right now, and wait to see what happens when the higher rates filter into the economy. But in order to not lose progress, I’d set the messaging very clearly. I’d be clear that a pause in rate hikes is not a change of course. Inflation is still a problem and I’d be clear that the laser focus is still on inflation, but in order to facilitate a soft landing, we’re pausing for now. If we don’t see progress on inflation in the next few months with the pause, then I’d make clear to expect a very large rate increase. Last year the rate increases were 0.75%—I’d make it clear that if the pause shows inflation is still here the market can expect a 2% rate hike, or higher, immediately.
This has two advantages, as I see it. First, if inflation is already tamed, then there is no need for more rate hikes so this avoids damage to the economy. Second, this makes clear that people should not change their behavior just because the rate hikes are paused. As I’ve discussed before, inflation expectations and the way people behave because of their expectations actually impact inflation a lot. People shouldn’t change their behavior right now, and a clear message from the Fed might allow them to change their direction with interest rates, and not induce a behavioral change in the markets.
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