Fighting Inflation or Finding It?
Current discussions of the Fed “fighting” inflation often miss the equally important and related question of how the Fed “finds” inflation.
There is a common view of the Fed as a gladiator with interest rates as its weapon in defense of price stability and maximum employment, but this is a relatively new phenomenon. It wasn’t until Volcker’s hikes in 1979 that this image of the Fed emerged. Even in 1977, with Section 2A’s addition to the Federal Reserve Act, price stability and maximum employment are described as the effects of full capacity utilization rather than competing goals monetary policy can pursue. In our present state, however, Powell has been quite clear in embracing this more powerful view of the Fed, referencing his dual mandate multiple times in his February 1st press conference.
With this in mind, we ask how exactly Powell is finding inflation. Whether it’s CPI, PCE, Core PCE, or Services PCE minus energy and housing, the best way to measure inflation is to know how the Fed finds inflation. Uniquely, Powell has shared his preferred measures of inflation more thoroughly than practically any Chair in history. On November 30th, Powell broke up core inflation into three categories: core goods inflation, housing services inflation, and inflation in core non-housing services or NHS. After the most recent CPI print, we can estimate where each area stands.
Core goods - Despite the .1% uptick in January, which most analysts have treated as unreflective of future trends, this category is the most straightforward with broader declines stemming from normalizing supply chains and pandemic goods demand shifting back to services.
Housing inflation - It is too early to make sense of the .7% monthly increase because of inherent lags, but Powell expects it to increase for a bit and come down later in line with rents.
NHS - This is where Powell has spent most of his time and is also what makes him the most uneasy. In short, NHS inflation has not decreased substantially and there needs to be much more progress in this area before Powell declares victory.
Powell noted on Feb 1st that “we have a sector that represents 56 percent of the core inflation index where we don’t see disinflation yet…So, for the third sector, we don’t see anything here. So I think it would be premature—it would be very premature to declare victory or to think that we’ve really got this”. He would later say that around 60% of this category is dependent on the labor market, making the White House’s new wage measure for core non-housing services particularly useful, given that it shows a significant decline in wage growth for months.
It is also worth noting that predicting NHS inflation based on CPI rather than the next PCEPI release on Feb. 24 should be done with a grain of salt since previous CPI measures have shown greater declines compared to the PCE measures. This is mainly due to the way health insurance prices are accounted for in CPI.
So what does this mean looking forward?
Here is Powell’s operating approach: he doesn’t anticipate cutting rates this year, and he insists that “The base case, for me, is that it will take some time. And we will have to do more rate increases, and then we’ll have to look around and see whether we’ve done enough”. Combining this with the bond market’s corrected rate cuts for 2023 and hotter inflation data due to seasonal adjustments, we can see that this reactive approach has spelled trouble for more than the Fed.
About the Author
Bennett Fees
Bennett is a student at UC Berkeley double majoring in Political Economy and Rhetoric. At Hoskin Capital, he specializes in investment-centered economic research. When he’s not reading, Bennett enjoys cooking and playing the drums.
