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With Inflation Moderating in Most Sectors, the Fed Should Consider Pausing Rate Hikes

“All You Need Is Love”

Ask any kid what the necessities of life are, and they will come back with a short list including food, water, shelter, and love. As adults we also understand the importance of energy (gasoline and electricity) and money in attaining these needs, as well as the many “wants” of life.

These very necessities–food, energy, housing, and wages–are the current drivers of inflation. This stands in contrast to earlier in the pandemic recovery, when “supply chain issues” caused widespread inflation across consumer goods.

So why then, if these necessities are so important (in life and as current drivers of inflation), am I focusing on data excluding them when calling for a potential pause on rate hikes? Because their prices are less responsive to interest rates.

Most consumer prices are impacted by interest rates; as rates go up so do borrowing costs, putting downward pressure on demand and prices. Food and energy prices, however, are primarily determined on their global markets (which our interest rates have little impact on). Food and energy are also, as just noted, necessities, meaning demand is less responsive to price changes because people need them regardless of price (in economics-speak, their demand is “inelastic“). Interest rates are simply not a good mechanism for impacting food and energy prices.

Shelter is another necessity that has an interesting relationship with interest rates. As the Fed increases interest rates to combat inflation mortgage rates go up, pricing some people out of buying homes and into the rental market. Supply in the rental market is fixed in the short term (due to construction time), and slow to increase in the longer term (largely due to restrictive zoning laws). Increasing demand and fixed supply, combined with higher operating costs and the expiration of pandemic era renter protections, have recently led to large increases in rent. In other words, the Fed’s primary tool for combating inflation could actually be contributing to inflation in housing (peoples’ largest expense category regardless of income).

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[Paul Krugman recently cited Jason Furman’s analysis claiming that rental prices are already moderating more than official BLS measures suggest, due to the Bureau’s methodology of tracking lease renewals in addition to newly signed leases. Newly signed leases, which in theory are more reflective of current market conditions than renewals, have been falling more steeply of late. These are two very smart people and their analysis is sound, hopefully it proves true and starts bearing out in official BLS rental indexes in the coming months.]

One Month Doesn’t Make a Trend

“Several Fed officials sought to temper investors’ enthusiasm, warning that there would need to be more evidence of slowing inflation before the Fed will let up on its campaign of rate increases.

‘It could easily go the other way in the next report, and I just don’t want to put too much weight on one month’s data,’ James Bullard, the president of the Federal Reserve Bank of St. Louis, said on Thursday.”

That’s fair, one month’s data doesn’t make a trend. But prices for “core” goods, whose supply chain issues drove inflation earlier in the pandemic, have leveled off since June. Prices for services other than rent (the remainder of what could be considered the “core”, or interest rate responsive economy) were flat in October, but inflation in the services sector has been more persistent. The provision of services is more reliant on labor than goods production is, and labor costs were still rising as of the latest September data.

Source: Bureau of Labor Statistics, Total Factor Productivity

The Producer Price Index (PPI), which tracks prices received by producers and is considered a bellwether of future consumer price movements, has also shown inflation coalescing around food and energy for about four months.

Table B represents intermediate demand goods even further up the supply chain, suggesting continued disinflation / deflation ahead for goods.

There is an element of “reading the tea leaves” when trying to determine the future trajectory of inflation, so the Fed should make use of all the high quality “tea leaves” it has at its disposal. What they show are four months of producer price data reinforcing that the current slowdown in “core” consumer inflation is not an aberration and will likely continue. Four months does make a trend in our current fast-moving environment, and the Fed will have the benefit of two more months of data before the next interest rate setting (“FOMC”) meeting (as well December labor cost data). This will also give the Fed time to see if Furman is correct about moderation in rental markets.

In June 2021 I wrote that we should “Keep Calm and let the Fed Carry On”—asserting that the Fed is an independent, expert body that knows what it is doing. The Fed is still independent and full of experts, but these experts are human and therefore need to check their biases and not be overly risk averse. Every large-scale economic policy carries risks, but the risk of the Fed waiting on rate hikes seems negligible (inflation has moderated if not yet begun to reverse), while the downside of unnecessarily raising interest rates is very real–we could still be facing a recession, especially given uncertainties in the global economy. The higher the interest rate the greater the drag on the economy, so raising rates in the name of fighting inflation–if inflation continues to be driven by markets that are not responsive to interest rates–doesn’t make much sense.

The Fed must also avoid the common mistake of fighting the last war; after in hindsight not doing enough to combat inflation in 2021, it must resist the urge to overcorrect with unnecessarily aggressive rate hikes now. The “smooth landing” of disinflation without a painful recession we all hope for is within reach. I would argue we are currently on that path, and while factors outside America’s control could always derail us, hopefully an overly risk averse Fed does not.

Purposefully Misleading “Forward Guidance”?

My best explanation, or perhaps hope, for what I see as unnecessarily hawkish rhetoric from the Fed, is that it is using “forward guidance” in an unusual manner. “Forward guidance” is exactly what it sounds like: “a tool that central banks use to provide communication to the public about the likely future course of monetary policy.”

Forward guidance is usually meant to be as straightforward as possible, but these are unusual times. The Fed may be trying to manifest the future we all want–the “smooth landing” of disinflation without a recession–by purposefully giving stricter guidance than it hopes to have to follow through on.

In other words, the Fed could be trying to impact peoples’ “inflationary expectations”. If people believe the Fed will act aggressively to keep inflation down, they may be less likely to buy more things or demand higher wages in anticipation of even higher future prices, pushing back on those sources of inflation. (It is commonly accepted by economists that inflationary expectations can have a self-fulfilling affect on future inflation rates.) As mentioned earlier, labor costs seem to be the most persistent driver of inflation that is (somewhat) in the Feds control right now, so managing inflationary expectations is a top priority for the Fed.

The Fed can always say one thing now while ultimately making policy based on not yet available data. I hope it is engaging in this tactical (and forgivable) misdirection, because if inflation continues on its current path, actually carrying out the rate hikes the Fed has been signaling would be poor policy. I am not advocating for reducing rates yet, but if two more months of encouraging consumer, producer, and labor price data come in, the Fed should pause rate hikes during the next FOMC meeting Feb 1st.

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Inflation Reduction Act? How Can Spending Be Disinflationary?!

Well a couple of ways, but first, a quick primer on whats been going on with prices lately

Overall, inflation is a function of aggregate demand (henceforth referred to as “demand”) and aggregate supply (“supply”). Demand is the sum of Personal Consumption (C), Investment (I), Government Spending (G), and Net Int’l Trade (Exports – Imports). Supply is all the goods and service producers can supply, a function of the cost of labor (wages) and various inputs (materials, energy, etc.). Consumption accounts for by far the largest portion of the U.S. economy, roughly 70% of demand. Different markets, both in different areas and for different goods or services, realize different inflation rates (some markedly so). To keep things relatively simple, for now lets just consider overall price levels.

Early in the pandemic, savings increased (for many) due to a combination of stimulus money and restrictions on many things people typically spend disposable income on. Once vaccines came out and the economy reopened, people were flush with cash (demand increased), but supply chain issues, global events (Russia-Ukraine War, China’s Zero-Covid policy), and shortages of workers (as COVID reoriented people’s calculus on what they are willing to do and for how much), caused input shortages and increased costs for producers, some of which were passed on to customers in the form of higher prices.

Hindsight is 20/20 as to whether the government “spent too much” during COVID. In the decades preceding the pandemic, increases in demand had been absorbed by a private sector eager to increase supply in order to reap greater profits, with little impact on inflation; globalization created a seemingly endless supply of “stuff” in wealthy countries like America. It was reasonable, if ultimately wrong, to use the models of recent history to forecast what would happen going forward. Early in the pandemic the primary focus was on shoring up demand and reducing personal hardship, which is why the CARES act and subsequent extensions of enhanced unemployment insurance (UI) benefits passed with bipartisan support–inflation simply wasn’t on most lawmakers’ radars.

If the Democrats made a unilateral mistake, it was parts of their American Rescue Plan (ARP)–stimulus checks and extending enhanced UI benefits–that were no doubt politically popular at the time but may have fueled inflation by increasing demand at a time the economy couldn’t absorb it. Some parts of the ARP, particularly the expanded child tax credit and aid to state and local governments, were needed (the latter likely had little impact on inflation; more on that in a moment when we discuss the “multiplier”.) But it is fair to say that Democrats may have overreached with some aspects of the ARP.

I have focused on fiscal policy (spending) because that is the primary story with respect to inflation right now. Yes, the Fed can also impact prices by increasing interest rates (lowering consumption and business spending.) But raising rates comes at a cost to the labor market, one which the Fed didn’t want to take in 2021 when full employment seemed like the more pressing of its dual mandates (and inflation was seen as being transitory.) Furthermore, real consumption has returned to be more-or-less in line with what it would have been if COVID never happened, meaning right now inflation is primarily due to the supply-side factors noted earlier, which the Fed has little power to affect regardless of how much it chokes off growth by raising interest rates.

Not all fiscal policy is equal, that’s on purpose

Not all government spending is equal in its intended goals (obviously, specific programs are sold to the public to address specific needs.) Less obviously, not all spending is equal in its impact on inflation. The extent to which government spending impacts demand (and therefore inflation) is known as the “multiplier”–how much each dollar of government spending increases economic output.

The exact multiplier for a policy is never truly known, there are too many variables to perfectly tease it out in the short run, let alone over time. Generally speaking the multiplier is a function of how much spending affects personal consumption, which as mentioned before makes up about 70% of U.S. GDP and is the surest route to short-term economic impact.

Fiscal policy can be predominantly “counter-cyclical”, directly targeting short-term consumption and business spending. Examples include COVID era spending policies like stimulus checks, enhanced UI benefits, and the Payroll Protection Program, or tax cuts (like the Bush era tax cuts, and a surprisingly large portion of Obama’s post-Great Recession stimulus package.)

These policies main goal is to have a high multiplier–they leverage government money to try to increase demand at a time when the private sector is pulling back (hence “counter-cyclical”.) Normally, as demand rises, businesses hire more people to meet that demand (increasing supply by adding jobs), starting a virtuous cycle of growth in the economy; it goes without saying that the past two and a half years have not been normal times in any sense, including economically.

Alternatively, fiscal policy can be predominantly structural–aimed at addressing the root causes of poverty or other structural inequalities or deficiencies in society. These policies also increase demand by increasing government spending, but their multiplier is lower than counter-cyclical “stimulus spending” because the money is going to longer-term investments in public goods and human capital, not to putting money in people’s pockets to consume more now.

So when is fiscal policy disinflationary?

Fiscal policies that increase demand typically aren’t disinflationary in the short run, but they can have essentially no impact on inflation depending on their multiplier. In the long run, some types fiscal policy can be quite disinflationary.

The Inflation Reduction Act is disinflationary for a straightforward reason–it actually lowers demand, with more tax revenue being raised than money spent. It will also help bring down the cost of prescription drugs by allowing Medicaid to negotiate directly with pharmaceutical companies.

The infrastructure bill is disinflationary in the long run because it will make us more productive. Investments in concrete infrastructure and ports will help people and products get where they’re going quickly and safely. Replacing lead waterpipes will lead to less stunted cognitive development in our youth. Investing in broadband will help bridge the “digital divide” that cuts many poorer and rural people out of the 21st century economy. The bill had a negligible impact on inflation in the short run (notice no large increase in real GDP from before it was passed in Q3 2021 till now) despite injecting a large amount of government money into the economy ($550 billion in new spending), because the money is being disbursed over a longer period of time and isn’t going directly into people’s pockets.

Even after passing the infrastructure bill, the Inflation Reduction Act, and the China-countering Chips and Science Act, many parts of “Build Back Better” (BBB) still need to be passed. 17 Nobel prize winning economists signed a letter saying that, in addition to its primary benefits, BBB would “ease longer-term inflationary pressures” despite its huge price tag. Specifically, investments in affordable childcare and universal pre-K would bring down the cost of childcare and bring caretakers back into the labor market, increasing the supply of labor and easing pressure on wages. More seats at community colleges and apprenticeships would create alternate paths to gainful employment, increasing productivity, reducing student loan debt, and driving down the cost of a four year degree. Allowing anyone to buy into a Medicaid “public option” would inject competition into the health insurance market, lowering prices. These are exactly the “kitchen table” economic policies that Democrats (and ideally some Republicans) should campaign on in 2022 and ’24.

Lawmakers should also embrace the concept of “supply-side progressivism”, another example of spending that can reduce inflation (note that it complements and synergizes with the more traditional approach of providing financial support to poorer people, it does not replace it.) Supply-side progressivism means the government actually creates the things the private sector does not supply enough of affordably. By taking ownership the government removes the need to make a profit, making the product more affordable (like Medicaid vs. private insurance.) Generally speaking profitability is of course desirable, but some markets supply things that are so important for society and the economy that affordable access is more important than profits. Removing the need to profit, and directly increasing supply, can greatly reduce price pressure in imperfect markets.

Most markets function well in the U.S. and require minimal intervention, but not all of them. Some markets, particularly those for necessities, deviate greatly from the textbook concept of “perfect competition”, and thus are prime candidates for supply-side progressivism. Housing, higher education, healthcare, and childcare–all areas where price increases have far outstripped overall inflation in recent history–are good places to start. Looking at how prices have increased for these things over the past four decades; consider the cost that has imposed on all Americans (particularly the poor), and the strain it has put on the federal budget. Clearly the status quo isn’t working.

(Value = % change since July 1982. For example, tuition, fees, and childcare have increased 926.94% over the last 40 years, compared to a 302.84% increase for all items)

Don’t get me wrong, college is still a good investment for those who graduate from a good school with a degree. But the ability to get into a good school–and then remain in until completion–has increasingly become a function of family wealth. Of course there will always be anecdotal examples of social mobility in a country as large and advanced as America, but on a macro level the “American Dream” is no longer attainable for most.

The Inflation Reduction Act, and any future spending proposed to address structural deficiencies in our society, will be attacked as reckless–“Spending?! With inflation as high as it is!” This is a gross oversimplification. For one, there are reasons to believe inflation has already peaked and will start to come down in the coming months. But more generally speaking, some types of spending–the types America has sorely needed for decades–would have little impact on inflation in the short run, and actually reduce it in the long run (in addition to all of its other primary benefits.)


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Inflation: Keep Calm and Let the Fed Carry On

Anticipating concern over recent inflation numbers, the White House Council of Economic Advisors (CEA) put out a useful historic primer on recent periods of higher inflation:

“Supply chain disruptions are having a substantial impact on current economic conditions. Economy-wide and retail-sector inventory-to-sales ratios have hit record lows; homebuilders are reporting shortages of key materials; and automakers do not have enough semiconductors. Elevated consumer demand is adding fuel to the fire. Travel demand, for example, has returned much more sharply than expected, which is straining airline operations. Similarly, total vehicle sales in April more than doubled from a year prior, which is leading to empty dealer lots. The combination of a spike in consumer demand and a supply chain that is not fully operational has contributed to rising prices.

If actual inflation is affected by inflation expectations—and if expectations are in part formed by recent experiences (what economists call “adaptive” expectations)—then one risk is that transitory supply constraints and pent-up demand could have more persistent effects by raising longer-run expectations of inflation. On the other hand, businesses and consumers may “see through” supply disruptions and not change their longer-run expectations significantly.

In this blog post, we examine previous periods of heightened inflation and see what they can teach us about inflation in 2021…No single historical episode is a perfect template for current events. But when looking for historical parallels, it is useful to concentrate on inflationary episodes that contained supply chain disruptions and a spike in consumer demand after a period of temporary suppression. The inflationary period after World War II is likely a better comparison for the current economic situation than the 1970s and suggests that inflation could quickly decline once supply chains are fully online and pent-up demand levels off. The CEA will continue to carefully gauge the trajectory of inflation.”

How people expect prices to behave can actually affect price levels. If people think prices will continue to rise, and increase their purchases beyond what they normally would to hedge against expected future increases, that itself can lead to greater inflation. If you (as I) believe the forces of supply and demand will eventually even out any market mismatches, then expectations are arguably the “most variable” of the variables affecting inflation right now (at least in an advanced economy like America’s.)

One important difference today compared to earlier periods examined by the CEA is the hyper-partisan nature of all policy debates, and how that plays out in the news and ultimately affects peoples’ beliefs. When people are subjected to continuous fear-mongering about inflation it is likely to impact their expectations, leading to greater inflation than the underlying economics alone would have yielded. In our world of social-media fueled “echo chambers” and the confirmation bias it enables, psychological forces could play an outsized role in the levels of inflation we ultimately realize.

For what its worth–hopefully a lot–most economists believe current high inflation figures are partially due to the “base effect” (lower inflation in 2020 due to pandemic related shutdowns making over-the-year increases look larger than they otherwise would be) and will be “transitory” (shorter-term, subsiding once the effects of supply chain bottle necks and pent-up demand work themselves out.)

Monetary policy is one area where we should trust the experts; it is inherently complex, and there is good reason to think ideology won’t dominate. Why? Because inflation has the ability to hit peoples’ wealth and sense of financial security in ways that taxes cannot; regardless of your political affiliation, you probably have no interest in seeing your lifetime of hard earned savings inflated away due to mismanagement. So we have Fed Chief Jerome Powell (a Trump appointee) working closely with former Fed Chief Secretary Yellen (who was appointed to her various roles by Obama and Biden.) The two have historically had very different views on appropriate monetary policy, but as dedicated public servants with “skin in the game”, they both want to get monetary policy right.

There is also little reason to think the types of spending Biden is proposing would be particularly inflationary. The administration is actually framing its proposals as inflation reducing in the middle-to-long run. They argue that by investing in our infrastructure, human capital, and the burgeoning green economy, gains in productivity will allow businesses to pay higher wages and stay profitable without needing to drastically increases prices.

The spending in Democratic proposals would also be spread out over time, meaning any inflationary aspects (should they be felt before productivity boosts are realized), mainly occur after the transitory post-COVID pressures subsided. It would not be inflation on-top of what we are currently experiencing.

The Federal Reserve has the “dual mandate” of promoting price stability and full employment. In determining appropriate monetary policy, context matters—despite a growing economy and low interest rates, America has experienced lower-that-desired inflation (below the 2% annual target) for much of the past decade. This is another reason the historically hawkish Powell is comfortable letting inflation “run hot” for a little while in order to help return the labor market to full employment. This strategy, championed by the unsung hero of the Great Recession Ben Bernanke, is known as “temporary price level targeting“.

In other words, keep calm and let the Fed (and CEA) carry on. It knows what it is doing. It proved that during the Great Recession when it ignored these same disingenuous warnings and saved our economy, while conservatives fear-mongered about inflation and obstructed an adequate fiscal response in Congress. Sound familiar?

Fools, Fanatics, and Wiser People

“The whole problem with the world is that fools and fanatics are always so certain of themselves, and wiser people so full of doubts.” — Bertrand Russel

I cannot tell you with certainty how long higher inflation will last–no one can. Uncertainty about how COVID variants will disrupt operations in countries with lower vaccination rates makes it difficult to predict exactly when global supply chains will normalize. The possibility that different components of the basket of goods that make up the topside inflation number may experience price increases at different points in time could also draw out this transitory period.

Even with those uncertainties, I can say with confidence that I think any higher-than-desired inflation will be transitory, and that the Fed has the tools to bring inflation down if need be. I can tell you there are real costs to people and our economy from unnecessarily tightening monetary policy too soon. I can also tell you that those who are saying with certainty that a sustained period of high inflation will (or already has) taken off–so called “Bidenflation”–have ulterior motives for doing so. They also have a terrible track record of predicting these sort of things; remember “Obamaflation“? Probably not, because it never actually materialized.

Most importantly, forgoing this historic opportunity to pass the biggest investment in America and its people since The New Deal in the name of sustained higher inflation that will likely never materialize, and if it does can be managed, would be the height of stupidity–the type of stupidity that would reverberate through history. Can you imagine America without The New Deal or Great Society (or the world for that matter, considering what their absence likely would have meant to the the Cold War effort?) No, you cannot–it is inconceivable. America again finds itself needing to prove democracy can work not only for its own people, but as part of a new “Cold War” against the forces of authoritarianism—the stakes for getting these things done could not be higher.

Senator Joe Manchin, the man who above anyone else needs to be convinced of this so these plans can be passed via reconciliation, recently said he is “going to talk to some economists” about the possible inflationary effects of these proposals. Look, if he wants to find economists to tell him to moderate due to inflationary concerns, he will find them. However those views would not represent the beliefs of most economists, and run counter to the lessons of recent history and the demands of the moment.

Most economists (like most subject matter experts), due to some combination of integrity and ego, actually care about being right. They agree the benefits of expansionary fiscal and monetary policy right now far outweigh the unlikely costs of runaway inflation. Recent history tells us we should not believe the people who fear-mongered about inflation during The Great Recession for the same regressive reasons they are today. Those opposed to Biden’s proposals believe if they can delay them long enough, they can kill them by flipping the balance of power in Congress back to the GOP. They are right, and that cannot be allowed to happen.

Ultimately the need to act now and adjust later comes down to how fiscal and monetary policy are passed. There is a small window to act on fiscal policy; when is the next time America will emerge from a such a crisis, with people demanding these sort of large scale investments, and with the party that is willing to pursue them controlling all the levers of federal policy-making? In the context of our grossly and increasingly uneven electoral playing field, probably not again in the foreseeable future. Monetary policy on the other hand, by virtue of being passed relatively smoothly by the independent Fed, is much more nimble and can be adjusted to meet any inflationary consequences of this spending should they ever come to pass.