Fed’s Dilemma: Inflation Slows, Rate Cut Looms, but Long-Term Outlook Uncertain

The Long View

The Federal Reserve is scheduled to meet later this week and is expected to keep interest rates steady at between 5.25% and 5.5%, where they have remained since July. In addition to assessing current economic conditions, officials need to evaluate inflation, which ended 2023 in better shape than initially projected. The original median estimate for the Personal Consumption Expenditures price index predicted a year-end figure of 3.1%, while the core rate (excluding food and energy costs) was expected to reach 3.5%. In reality, the two indicators came in at 2.7% and 3.2%, respectively, in the last quarter of the year. However, this data masks a weakening trend. Core inflation, on an annualized basis, has remained below 2% for the past seven months and has continued to decline. Policymakers are concerned about this reversal and are hesitant to declare victory over inflation. There is also a risk of inflation dropping below the Fed’s 2% target, which could lead to deflationary pressures and economic challenges.

Prior to the pandemic, the Fed struggled to achieve its inflation target consistently. Even though there was a significant increase in prices during the pandemic, the long-term trend of the Personal Consumption Expenditures index indicates that inflation is only approximately 2.1% higher than it would have been if the Fed had consistently met its inflation goal since adopting it in 2012.

Persistence of Inflation

The challenge for the Fed lies in determining whether the world is returning to pre-pandemic norms, where inflation of 2% or slightly lower was considered normal. Various factors, including labor market tightness due to population aging, government deficits, and global trade frictions, suggest that the situation might have changed. The persistence of inflation is a key concern for policymakers. While they have dismissed arguments regarding the difficulty of reaching the “last mile” in terms of inflation, they view it as a matter of time. If certain goods and services continue to experience rising prices, policymakers believe that maintaining the current interest rate for a longer period and gradually reducing it would be a more effective solution compared to raising rates again. Policymakers also differentiate between generalized inflation and changes in relative prices that can result from temporary imbalances or other factors that are not necessarily inflationary. However, when a significant portion of the economy is facing rising prices without offsetting low inflation or price declines in other sectors, policymakers remain cautious.

Housing poses the most significant challenge in terms of inflation. Many policymakers expect a slowdown in housing-related inflation in the coming months. Former St. Louis Fed President James Bullard, now the dean of Purdue University’s business school, suggests that based on the current data, a quarter-point reduction could be justified. However, it is crucial to communicate that such a move would be a technical adjustment rather than an attempt to stimulate the economy, given the falling inflation in an otherwise resilient economy.