The Federal Reserve should declare an immediate truce in its war on inflation and hold its benchmark interest rate steady, rather than raising federal funds by half a percentage point to a range of 4.25% to 4.50%, as expected at the meeting that ends Wednesday.
With relatively benign reportt on the November consumer price index released Tuesday, the Fed now has “compelling evidence” that it has achieved its immediate goal of seeing a significant slowdown in inflation.
CPI was better than expected in November, with headline inflation rising just 0.1% (1.2% y/y) and core inflation rising 0.2% (2.4% y/y).
The US stock market
on Tuesday initially hailed the CPI report as confirmation that the Fed could start easing, but by midday the realization hit that the Fed will continue to raise interest rates.
Better than the media says
The CPI report was actually better than it is being portrayed by the media, which continues to focus irrationally on year-over-year changes in inflation instead of looking at what has happened since the Fed started raising interest rates nine months ago since. For example, what are we going to make of. this incoherent New York Times headline: “US inflation cools as consumer prices rise 7.1 percent”?
If we don’t want to miss the turning points, we need to shorten our horizon to something less than a year, but not so short that it’s all noise and no signal. Three months is right.
In March 2022, when the Fed first raised interest rates, inflation was accelerating. From January to March, the CPI had increased by 11.3% annually. It was an alarming rate of inflation that required action from the Fed.
But then the Fed raised interest rates at six consecutive meetings, from near zero to nearly 4%, and now inflation is slowing. From September to November, inflation increased by 3.7% annually.
This is a significant advance in the most relevant inflation measure.
The wrong perspective
The progress is much less clear when the numbers are reported on a year-over-year basis, which most media do. From November 2021 to November 2022, inflation rose 7.1% — but that number is meaningless to our understanding of what the Fed has accomplished because that time frame also includes five months of high inflation from before the Fed acted.
Because interest rate hikes take some time to affect prices and the economy, they only really started to bite in July. In the five months since then, inflation has fallen to a 2.5% annual rate, which is noticeable to anyone looking. The unprecedented increase in interest rates is working to cool the price increases.
The progress is even greater when you consider that almost all of the inflation we’ve suffered recently comes from higher rents, which are now rising by 10% annually in a belated response to last year’s incredible 20%+ increase in house prices and tight rental markets.
Rents are still rising as house prices fall
Home prices have now begun to fall in most regions of the United States. Rents for new tenants have also started to fall, but rents paid by continuing tenants have lagged behind and may take another year or longer to catch up, according to research by economists at Goldman Sachs. This is because rents on existing tenancies tend to reset to zero on an annual basis.
“ Rents are used to calculate costs not only for renters but also for homeowners. It’s as if we measured champagne prices by looking at how much beer costs. “
With more than 900,000 multifamily units now under construction, supply constraints will soon begin to ease, reducing pressure on rents as these units come on the market, likely in the next year or so.
Rents have an overall impact on the CPI because rents are used to calculate costs not only for renters but also for homeowners. It’s as if we measured champagne prices by looking at how much beer costs. Yes, there is some correlation most of the time, but not always.
Using rents to measure homeowners’ costs might be an acceptable method in normal times, but not now. Based on the rise in rents, the CPI showed housing costs for homeowners rose 8% annually in November. Nobody believes it’s true. Most homeowners have a fixed-rate mortgage, so repayments and interest payments have not increased.
The right perspective
The best thing to do in this situation is to recognize that we need to exclude shelter costs (which account for a third of CPI) if we want to see where underlying inflation is headed.
“Substantial disagreement about the proper way to measure shelter inflation argues for looking at inflation measures that place less weight on shelter inflation, not more, when the decision is of greater consequence,” Goldman Sachs economists Ronnie Walker and David Mericle wrote in a published note . in October.
CPI excluding shelter fell 0.2% in November and has risen by just 1.3% annually over the past three months.
Even Fed Chairman Jerome Powell has acknowledged that a sudden drop in home prices won’t show up in headline CPI for months, but he doesn’t act like he fully believes it. If he did, he would urge his colleagues at the Fed to pause now and let the full effect of 375 basis points of tightening work on the economy.
However, we know that the Fed will not pause. The Fed lost too much credibility last year when it missed the rapid rise in inflation as the economy emerged from its pandemic shutdown, and now the Fed is struggling to restore public confidence as an inflation fighter.
Unfortunately, that makes a recession almost inevitable because the Fed will do what it always does: raise interest rates too far and push the economy into a job-killing recession.
Rex Nutting is a MarketWatch columnist who has written about the Fed and the economy for more than 25 years.