Editor’s note: Joseph H. Davis is Vanguard’s chief global economist. The opinions expressed in this comment are his own.
The Federal Reserve is aware of the pain spiraling prices are causing Americans. At the recent Jackson Hole Economic Symposium, Fed Chairman Jerome Powell said that falling inflation “will also hurt households and businesses.” But what the nation’s central bankers are debating is what they would define as success in the fight against inflation and whether they might be willing to stop raising interest rates at the same time.
Clearly, the Fed still has work to do. The latest inflation report found that prices of consumer goods and services were 8.3% higher, on average, year-on-year in August. Although this represents a decrease from the previous reading, it nevertheless shows that the purchasing power of consumers at this level is still eroding, as wages do not keep up with the increase in prices. The broad US stock and bond markets have posted double-digit losses over the past 12 months, leaving investors’ portfolios even further behind in real (adjusted for inflation) terms.
As I mentioned earlier, the Fed will continue to raise its benchmark lending rate until inflation enters a sustained downward trajectory, falls below wage growth, and approaches the central bank’s long-term 2% target. But falling inflation alone does not mean the end of the Fed’s campaign. Instead, policymakers will take a more nuanced approach. I believe that rates will continue to rise until they are sure that “flexible pricing” and “sticky pricing” are under control. Also, consumers want to see evidence that they think prices are in the rearview mirror.
In the past six months alone, the Fed has raised the upper end of its short-term interest rate target range 10-fold—from 0.25% to 2.50%. Far from subtle, it has been one of the most aggressive changes in monetary policy in US history.
Before the Fed slows the pace and size of interest rate hikes, it will likely want to see a sustained three- to six-month slowdown in flexible prices, which apply to goods and services whose costs can rise or fall quickly. These include things like food, energy, and cars and trucks.
Today, gas prices have moved in the right direction, but most flexible-price items still remain high. Policymakers are almost certain to continue raising rates next week, raising the upper bound of their target to 3% or 3.25%.
When policymakers are comfortable with the direction of flexible prices, they want to make sure that sticky prices are also returning to their target. These are similar, but not identical, to so-called core inflation measures, which exclude food and energy prices. Sticky prices largely apply to services such as rent and medical care. They don’t change as much or as quickly as flexible prices.
Although headline inflation is easing, the trend between sticky prices and core inflation measures has yet to reverse. Shelter and medical care services, for example, are still experiencing price increases of around 6% year on year.
Inflation expectations are critical because they influence consumer and business spending and investment decisions that drive the economy. The median expected rate of inflation over the next 12 months fell to 5.7%, according to the Federal Reserve Bank of New York, down from 6.2% a month earlier. And they are at 4.8% measured by the University of Michigan, down from 5.2%. For now, inflation expectations aren’t raising alarms or prompting the Fed to raise policy rates faster, but the Fed would like to get closer to 2%.
As I believe the Fed wants to see signs of success in its campaign on three fronts – not only flexible prices, but also sticky prices and against inflation expectations – it could be a while before policymakers claim victory in their anti-inflation campaign.