“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.
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.
Normative Narratives 