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  • Writer's pictureTim Mahedy

Fed Hawkishness Won't Lead to Sharp Inflation U-turn

What the June 2023 FOMC Meeting means for the economy, inflation, and your business


3 THINGS YOU NEED TO KNOW


Inflation doesn’t do sharp U-turns. Since 1960, the monthly change in the core PCE price index has posted a negative number in only 17 out of a total of 761 months, or 2.2% of the time. Your children have a better chance of getting into Harvard. The picture doesn’t change much if you just look at periods where the economy was contracting. Core PCE inflation contracted only 8.4% of the time during recessions over the same period. In the high inflation recessions of the 1980’s, it didn’t contract at all. This suggests that even if the U.S. economy enters a recession later this year, it’s going to take a long while for inflation to fall back to the Fed’s 2% target (Figure 1). It doesn’t happen in our A/m baseline forecast until the fourth quarter of 2024.




Your financing costs are likely to stabilize around current levels. Inflation that is persistently above target will lead to a federal funds rate that is above 5.5% through at least the first quarter of 2024. That means your borrowing costs aren’t going down any time soon. But they probably won’t go up much either. If core inflation continues to slowly tick down, even if it’s still well above the Fed’s target, then policymakers will be cautious with further rate increases. Fed officials suggested as much in the June Summary of Economic Projections.

We have two more 25bps rate increases in 2023, with the first one occurring at the next meeting in July.


A recession is still as likely as a coin flip. So far, the economy has weathered the rapid rise in interest rates. Job gains in 2023 have been stronger than many expected, and consumer spending continues to hold up. That’s decreased the probability of a recession, but that likelihood is still high by historical standards. Monetary policy acts with lags (more on this below) and excess consumer savings that were acquired during the pandemic are expected to run dry by the end of year – two factors we believe will cause consumer spending to edge below zero at some point in the second half of 2023. That will likely tip the economy into a mild recession.


MORE DETAIL


What would make inflation ease faster-than-expected?

  • Even more cooling in shelter inflation. Housing accounts for roughly 15% of core PCE inflation. And it grew a rapid pace during the pandemic. Rising rates in 2022 caused new and existing home sales to crater. The drop in demand also lead to a drop in home prices over the second half of last year. Due to technical factors, there is a lag between monthly changes in home prices and what shows up in official government measures of inflation. Last year’s declines only recently started showing up in the PCE housing index. For the same reason, we’ll see some additional cooling in housing inflation this summer. If that cooling is more than anticipated, it could cause core inflation to drop faster than expected.

  • Healthcare inflation never takes off. Healthcare inflation is expected to increase over the next couple of years as insurers try to keep up with rising costs and use. Bigger healthcare price increases are not expected to outweigh declines in other areas, like housing, but will slow the descent of core inflation. If that rebound fizzles, then inflation could fall faster.


Shelter inflation probably won’t ease until at least the fourth quarter. Figure 2 shows the correlations between year-over-year changes in the PCE housing index and changes in various monthly lags of the S&P/Case-Shiller (C-S) Home Price Index. In other words, how correlated is the change in the C-S index last month with the change in the PCE Housing index this month? Do the same exercise, but now lag the C-S index two months. This is a good time to put in the typical statistical disclaimer that correlation does not mean causation. However, changes in the C-S index 18 months ago are highly correlated with changes in the PCE Housing index today. That lag suggests that the slide in the monthly C-S house price index that took place over the second half of last year won’t show up in the PCE Housing measure until the middle to late fourth quarter of 2023.





Key inflation measures may start to diverge. Methodological differences can sometimes cause CPI and PCE measures to diverge, sending mixed signals about the trajectory of inflation. How price changes in the healthcare sector are calculated, as well as how much it factors into the overall inflation number, are two of those big differences. In PCE, healthcare constitutes a much larger percentage of the overall index because it includes price changes in employer-sponsored healthcare insurance plans, CPI does not. That difference may lead to less easing in PCE inflation as it better reflects insurers raising prices to compensate for input and labor cost surges that occurred during the pandemic, as well as a rebound in demand for medical services that were put on hold due to safety concerns. The potential divergence between these two measures is important to keep in mind when thinking about the likely path of interest rates. Look to the Fed’s official target – core PCE inflation – as your guide.


The economy’s lagged response means more monetary policy uncertainty. A lot has changed since Milton Friedman famously wrote about the long and variable lags in monetary policy in 1961.1 Friedman noted that during expansions the lag could be as long as 29 months. But that was before forward-guidance and social media. The lags today are thought to be a lot shorter.2 But how much shorter is still not well established. Add in that interest rates affect the economy through different channels differently – mortgage rates go up quickly while the impact to consumer spending can take a lot longer, particularly when bank accounts are still stuffed with excess savings from the pandemic – and it becomes very hard to know when policymakers have done enough. During most of the second half of 2022, you could set your calendar to 75bps hikes every 6-8 weeks. This year, before June, you could pencil in 25bps every FOMC meeting. Going forward you’re going to be using that eraser a lot more.


REFERENCES


1. Friedman, Milton. A Program for Monetary Stability. Fordham University Press, 1960. https://books.google.com/books/about/A_Program_for_Monetary_Stability.html?id=AB-l1CMHBSoC.


2. Doh, Taeyoung, and Andrew T. Foerster. “Have Lags in Monetary Policy Transmission Shortened?” KcFed Economic Bulletin (blog), December 21, 2022. https://www.kansascityfed.org/research/economic-bulletin/have-lags-in-monetary-policy-transmission-shortened/.



 

Tim Mahedy is the Founder and Chief Economist of Access/Macro – a consultancy focused on uncomplicating the economy so that your business can make better decisions.


Disclaimer: The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. Access/Macro does not provide legal advice.



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