Inflation "cooling" and Fed "slowing"
2023 Prediction: Inflation Expectations > Fed Credibility
The Federal Reserve announced today that it is raising its target Federal Funds Rate to the 4.25 - 4.50 range, a half-point increase after a blistering year of rate hikes. My take is that the talk of inflation “cooling” and Fed “slowing down” are true only in the relative sense, and it’s more helpful to focus on absolutes and longer-term trends. With that in mind, here is a chart I put together with a data series with the Fed Funds Rate and the four-year average of annualized CPI inflation.
That red line represents what I think is a subconscious expectation among American shoppers. I also want you to notice that in the not so distant past, the Fed was plenty comfortable raising rates high above inflation, by 2+ percentage points in 2007 and 4+ percentage points in 2000. Notice, too, how quickly the rate hikes have been in 2022 — that black line is steep — more aggressive than any time in the past 35 years even before today’s move! (Cool chart from the Visual Capitalist here).
Do you really believe the current Fed is going to hold steady in 2023? Could be, but I just don’t think it’s likely. Seems more like the classic mistake of issuing a hope rather than a forecast. This announcement is less a credible commitment (see my italics below) than an effort to calm nerves and get that elusive smooth landing (via the AP):
More surprisingly, the policymakers forecast that their key short-term rate will reach a range of 5% to 5.25% by the end of 2023. That suggests that the Fed is poised to raise its rate by an additional three-quarters of a point and leave it there through next year (italics added).
The latest rate hike was announced one day after an encouraging report showed that inflation in the United States slowed in November for a fifth straight month. The year-over-year increase of 7.1%, though still high, was sharply below a recent peak of 9.1% in June.
The long-term inflation rate remains unacceptably high, but it’s true that this month’s monthly change in the CPI was small. It’s also true that the CPI has been remarkably steady for the past five months, meaning the annualized inflation rate over that span is 2.45%. That’s great, but nobody knows if it will hold.
I will likely and happily lose my bet with David Henderson about double-digit price inflation this year, but I’ll make a new bet that the Fed will find a need to raise rates in 2023 more than Chair Powell is saying publicly right now.
DISinflation expectations > Fed credibility. Recent inflation has been driven primarily by supply issues, which are correcting, so rate hikes are fighting a monetary theory ghost. As you point out, prices are already reverting to the mean in many cases and the area where rate hikes have had the most significant impact, real estate, has not yet impacted the CPI numbers because of the lag in the shelter portion of CPI. (h/t David Bahnsen) Barring a black swan event, my bold prediction is 0.25% rate cut by Dec '23 and fed funds rate will fall steadily in '24 as Japanification settles in.