Progress Has Been Made on Inflation. But It Gets Harder from Here.

The fight against inflation has dominated Federal Reserve policy for the past sixteen months. The Fed allowed inflation to run out of control in 2021 and early 2022 on a view that it would be “transient” and would come down on its own through reduced consumption, possible recession, and higher unemployment.

None of that happened. Consumption remained strong as a result of government handouts during the pandemic, suspension of payments on student loans, fiscal deficits and spending sprees, drawing down savings, and finally using up credit lines.

All of those trends may be coming to an end now and inflation has come down from the heights. But the Fed was asleep at the switch when the spending frenzy (and stock market bubble) were roaring for the past two years.

Finally, in March 2022, the Fed started to apply the brakes with a series of ten consecutive interest rate hikes that took the Fed Funds target rate from zero to 5.25%, with another 0.25% rate hike coming next week.

Inflation has come down from a high of 9.1% in July 2022 (CPI measured year-over-year) to 3.0% in June 2023. That’s progress, but not nearly enough given that the Fed’s target rate is 2.0%.

Unemployment remains at lows not seen since the 1960s, and GDP growth for the second quarter is estimated at 2.3% by the Atlanta Fed (we’ll have the actual number next week). At least for now, unemployment remains low, growth remains strong, and inflation is still too high.

This is definitely mission-not-accomplished for the Fed. So, expect more interest rate hikes before the end of the year. Yet, the situation might be worse than that for reasons described in this article.

The decline of inflation is not a linear process. The early gains were rapid and relatively easy. It was low handing fruit.

The later gains, including getting inflation from 3.0% to 2.0% are much more difficult. The reasons include the facts that used car prices are rising again, airline pricing power remains strong, Americans are spending more on travel and entertainment, and labor is gaining the power to get real wage increases through strikes and aggressive negotiations.

Even non-union labor is finding it easy to get a raise because of a skilled labor shortage and the difficulty employers have in hiring new workers. Those developments point to an even more dangerous situation for the Fed. The “transitory” narrative came from the fact that the 2021 inflation was coming from supply chain disruption.

That kind of inflation does tend to dampen itself as consumers reduce discretionary spending, although that took longer than the Fed expected. Now inflation is coming from the demand side in the form of wage increases. That kind of inflation feeds on itself as businesses raise prices to cover higher wages and employees demand more wage hikes to cover higher prices.

It’s a vicious circle last seen in the late 1970s. The solution then was 20% interest rates and the worst recession since the end of World War II. Let’s hope the Fed doesn’t have to go that far this time. But once the inflation genie is out of the bottle, one cannot rule it out.

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