Unpacking the details of last week’s consumer price index report, the news was good: Inflationary pressure continues to slowly subside, while an economic “soft landing” — in which the Federal Reserve is able to stabilise prices without causing a recession — is starting to look more realistic.
Unfortunately, it’s still too soon to take this much-desired outcome for granted.
The Fed will have another month’s data on consumer prices and other fresh information before its next policy meeting in September. Headline inflation might well be a bit higher by then, thanks to base effects dropping out of the reading and higher gasoline prices. But so-called core inflation seems to be moving the right way. If it falls again in August, as seems likely, investors will expect the Fed to pause its tightening. Many will bet that the next move on interest rates, though still maybe several months away, will be downward.
Yet keeping an open mind would be wise. The main reason is that the labor market, though cooling of late, is still tight by historic standards. Combining inflation of 2 percent (the Fed’s target) and an unemployment rate of 4 percent or less (at the moment it’s just 3.5 percent) would be quite an achievement. Two possibilities are more likely. One is that monetary policy is kept tight enough to beat inflation but causes a more abrupt slowdown. The other is that tightening stops prematurely, the labor market stays too hot, and inflation stabilises at more than 2 percent.
The Fed has rightly promised that it won’t settle for higher-than-target inflation, but it hasn’t explicitly said how patient it’s willing to be. Its most recent “dot plot” projected year-on-year inflation of 2.5 percent by the fourth quarter of next year and 2.1 percent by the end of 2025, with unemployment at 4.5 percent. This very gentle decline at little cost in forgone employment basically describes the hoped-for soft landing. If he could pull it off, Fed Chairman Jerome Powell would deserve a medal.
The problem is judging what level of interest rates is required to make it happen. At any given point, the Fed can’t know for sure how firmly (if at all) its policy rate is restraining demand. The so-called neutral rate (also known as r-star) is the rate that neither adds to nor subtracts from aggregate demand; it varies according to economic conditions and can only be estimated. With core inflation at more than 4 percent and broader financial conditions far from tight, the current policy rate of 5.25 percent to 5.5 percent likely exceeds the neutral rate — but not by much. Whether it’s enough to get inflation all the way back down to 2 percent remains an open question.
The Fed needs to be careful not to tie its hands. Without further clear progress on inflation, it shouldn’t guide investors to expect a prolonged pause in tightening, much less a move in the other direction. Any celebration would still be premature.
The Editors are members of the Bloomberg Opinion editorial board. Views are personal and do not represent the stand of this publication.
Credit: Bloomberg
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