Opinion: 3 things the Fed needs to see before it stops raising rates
Editor’s note: Joseph H. Davies is Vanguard’s Chief Global Economist. The opinions expressed in this comment are his own.
The Federal Reserve understands the pain surging prices are causing Americans. At a recent Jackson Hole economic seminar, Federal Reserve Chairman Jerome Powell said lowering inflation “will also lead to some pain for households and businesses.” But what the country’s central bankers are reluctant to discuss is what they will define as a success in their fight against inflation and, in turn, when they are willing to stop raising interest rates.
Clearly, the Fed still has work to do. The latest inflation report showed that prices of consumer goods and services rose 8.3% on average on an annual basis in August. While this is down from the previous reading, it shows that at this level, consumers’ purchasing power is still eroding as wages are not keeping pace with price increases. Broad US stock and bond markets have posted double-digit losses over the past 12 months, leaving investors’ portfolios farther behind in real (inflation-adjusted) terms.
As I discussed earlier, the Fed will continue to raise the benchmark lending rate until inflation enters a sustainable downward trajectory, falls below wage growth and approaches the central bank’s long-term target of 2%. But low inflation alone may not put an end to the Fed’s crackdown. Instead, policymakers are likely to take a more nuanced approach. I think they will keep raising prices until they are satisfied that the so-called “flexible prices” and “fixed prices” are under control. They’ll also want to see evidence that consumers think escalating prices in the rearview mirror.
In the past six months alone, the Federal Reserve has raised the upper limit of its target range for short-term interest rates 10-fold – from 0.25% to 2.50%. Far from being subtle, it was one of the most aggressive swings in monetary policy in US history.
Before the Fed slows the pace and scale of interest rate hikes, it will likely want to see three to six months of continued slowdown in flexible rates, which apply to goods and services that can rise or fall in cost rapidly. These include things like food, energy, cars and trucks.
Today, gas prices are moving in the right direction, but most flexible price items are still high. Policy makers are almost certain to continue raising rates next week, raising the upper limit of their target to 3% or 3.25%.
Once policy makers are comfortable with the direction of elastic prices, they will want to make sure that fixed prices are also trending toward their goal. They are similar, though not similar, to the so-called core inflation measures, which exclude food and energy prices. Flat rates largely apply to services such as rentals and Medicare. They don’t tend to change as often or as quickly as flexible pricing.
While general inflation has been declining, the trend between constant prices and core inflation measures has not yet shifted. Shelter and Medicare services, for example, are still seeing price increases of nearly 6% year over year.
Inflation expectations are fundamental because they influence consumer and business spending and investment decisions that drive the economy. Average inflation rates expected over the next 12 months have fallen to 5.7%, according to the Federal Reserve Bank of New York, down from 6.2% the previous month. They are at 4.8% as measured by the University of Michigan, down from 5.2%. For now, inflation expectations are not raising alarms or prompting the Fed to raise interest rates faster, but the Fed would like to see them fall near 2%.
Given my belief that the Fed will want to see signs of campaign success on three fronts – not only against flexible rates but also against fixed rates and inflation expectations – it may be some time before policymakers declare victory in their anti-inflation campaign.