The inflation story took a turn for the better on Thursday when the government reported that the consumer price index fell 0.1% from a month earlier. Policymakers at the Federal Reserve will play down the report’s significance and reiterate their commitment to keep fighting volatile prices. But in private, they have to be elated.
Consider the situation from the Fed’s vantage point. Less than two months ago, Chair Jerome Powell laid out his framework for thinking about inflation in a speech at the Brookings Institution. Today, most of his hopes and dreams are already being realized. Supply chains are healing and core goods prices are cooling while forward-looking gauges of market rents signal shelter inflation is poised to come down soon as well. Perhaps most important, central bankers have received encouraging evidence regarding core services excluding shelter — that all important, wage-driven component of CPI that Powell feared would be the hardest to tame.
Indeed, after stripping out rent and owners’ equivalent rent, core services prices are rising at an annualized pace of just 2.6% over the past three months. When Powell gave his Brookings speech, annualized three-month inflation in that category stood at 7.1%. Now, it’s essentially back to its pre-pandemic average.
Even before Thursday’s report, there was growing evidence that inflationary pressures were ebbing in core services outside of housing. An Institute for Supply Management report on Jan. 6 showed a measure of prices paid by service providers declined for a second month. Meanwhile, increases in average hourly earnings — which Powell has flagged as a chief potential driver of service sector prices — have moderated significantly. While wage growth is running above pre-pandemic norms in both the goods and services sectors, the latter has experienced a sharp downswing.
Of course, Powell and his colleagues will continue to argue that inflation remains “too high,” but this is something of an oratorical trick. If traders sniff out lower inflation and the end of interest-rate increases, markets will rally further such that bond yields and borrowing costs will drop, and — in the Fed’s view — that could revive inflation. In a technical but misleading sense, it is true that the Fed is still missing its 2% inflation target. With the latest report, the year-over-year change in the headline consumer price index stands at 6.5%. That should leave the Fed’s preferred inflation gauge, the personal consumption expenditures deflator, at around 4.7%, according to Bloomberg Economics calculations — well above the 2% target. The Fed will probably raise interest rates by an additional 50 basis points or so to make sure it gets the job done.
