The Not-So-Great News About Lower Inflation

The news that consumer prices fell in December from November — yes, monthly inflation was negative — was not as wonderful for the Federal Reserve as you might expect. Fed officials are trying to persuade the financial markets and the public that the fight against high inflation is far from over, and this data point doesn’t help make its case.

These convolutions require a bit of explanation. But first, take a look at this remarkable chart of the Adjusted National Financial Conditions Index, which is maintained by economists at the Federal Reserve Bank of Chicago.

The chart shows that the financial markets aren’t doing what the Fed wants them to do. The Fed is trying to wring out inflation by cooling off the economy. Its main method is to raise the federal funds rate, the short-term interest rate it controls. That’s supposed to tighten lots of other financial conditions: pushing up longer-term interest rates, pushing down the stock market and so on, which would soften up the labor market and reduce inflation generated by higher wages.

Look at what’s actually happening, though. Back in early July, financial conditions were more restrictive than the long-term average. Now they’re less restrictive than average — even though in the interim the Fed has raised its target range for the federal funds rate by nearly 3 percentage points. (The zero line in the Chicago Fed’s adjusted index represents average financial conditions given the current level of economic activity and inflation.)

Why aren’t the markets doing what the Fed wants? Investors seem to have concluded that although the Fed is raising interest rates now, it’s going to start cutting them by the end of the year — either because it has won the war on inflation or because the economy is in trouble, or some combination of the two. Judging from futures trading on the Chicago Mercantile Exchange, traders expect the federal funds rate to peak in June and be back around where it is now by December. (Complicating matters: December’s slight price decline was fully expected, and many traders had bet on an even bigger slowdown in inflation.)

So here’s the paradox for the Fed: It has managed to persuade the financial markets that it really will lower inflation. But the more credible its promise is, the more investors start looking past the current tightening cycle to the subsequent loosening cycle. Fed officials worry that the resulting easy financial conditions will keep the labor market tight and wage pressures strong, preventing them from hitting their inflation target. So they’re forging ahead with rate hikes even as inflation declines. It’s a strange pas de deux that could wind up being very bad for the U.S. economy.

“There are a lot of moving parts here,” Tim Duy, a University of Oregon professor of practice who is chief economist for SGH Macro Advisors, told me.

The clearest evidence that something is wrong is that short-term interest rates are high (signaling the market’s belief that the Fed is determined to keep raising them) while long-term interest rates are low (signaling the market’s belief that rates will be lower in the future, either because of low inflation or a recession or both). This is the inverse of the usual pattern, in which long-term rates are higher than short ones. It’s known as an inversion of the yield curve, and as I wrote last month, it’s a reliable recession signal.

The alarm bell that was ringing loudly last month is ringing even more loudly now. In December, the yield on three-month Treasury bills was 0.8 percentage point higher than the yield on 10-year Treasury notes, which at the time seemed huge. Now the spread has grown to 1.2 percentage points. That’s bigger than any previous gap in records maintained by the Federal Reserve Bank of St. Louis going back to 1982.

Jerome Powell and other Fed officials worry that if they stop raising rates now, or even slow the rate of increase too much, they won’t manage to get inflation back down to their target of 2 percent a year. It’s true that the monthly decline in prices in December was a one-off, caused mostly by a big decline in gasoline prices and airfares that won’t be repeated every month. Prices excluding food and energy rose 0.3 percent in December from November. Duy, the Fed watcher at SGH Macro Advisors, points out that while goods price inflation has tapered off, services inflation and wage pressures remain.

But the opposite risk is that the Fed will tighten too much. Fed officials are starting to take that risk into account. After making four consecutive giant-size increases in the federal funds rate last year, the Federal Open Market Committee put through a smaller hike in December and may go even smaller at its next meeting in February, judging from recent statements by committee members.

On the other hand, while Fed officials may be talking about slowing the rate of increases, they still seem more or less united about eventually getting the federal funds rate a bit above 5 percent, which is three-quarters of a percentage point higher than it is now. “The Fed needs to see clear, clear evidence that inflation has left the system in its entirety,” James Knightley, chief international economist for ING, told me.

Perhaps in part in reaction to the Fed’s hawkishness, the confidence of U.S. chief executives has collapsed. According to a Conference Board quarterly survey, in the spring of 2021 its aggregate measure of confidence was the highest since records began in 1976. By the fourth quarter of last year it had plunged to the lowest since the global financial crisis in 2009 — worse even than during the pandemic recession in 2020. If the chief executives act on their bearishness — not a certainty — they could start to cut back on advertising, equipment purchases and hiring, making their forecasts into a self-fulfilling prophecy.

Christina Romer, the outgoing president of the American Economic Association, said at the big economics conference in New Orleans this past weekend that based on her research with her husband, David Romer, Fed policymakers should not be surprised or frustrated that the interest-rate increases they’ve already put through have failed to slow the underlying inflation rate. Judging from experience, those past increases are likely to start slowing inflation — and raising unemployment — right around now.

“Policymakers are going to need to dial back” on raising rates before the problem of inflation is “completely solved,” said Romer, an economist at the University of California, Berkeley, who was chair of the President’s Council of Economic Advisers in the Obama administration. If instead they keep raising rates until inflation is utterly vanquished, she said, “they almost surely will have gone too far.”

The Readers Write

Concerning your newsletter about lower attendance at the big economics conference: The economists will do fine. I am an 83-year-old retired law professor from the University of North Carolina at Chapel Hill. We law professors used to have one big meeting in December that functioned as a hiring hall for new entrants into teaching and also functioned as a professional meeting for those already in the profession. That was split in the early to mid-1970s. Now people who serve on the personnel committee at a law school may attend both meetings.

William Turnier
Chapel Hill, N.C.

Quote of the Day

“Until November 2010, Ghana was considered ‘low-income,’ that is, a poor country. But between 5 and 6 November 2010, its G.D.P. increased by 60 percent overnight, turning it officially into a ‘low-middle-income’ country. The reality had not changed, but the G.D.P. statistics had, because the country’s statistical agency had updated the weights used in calculating the price index, and consequently real G.D.P., for the first time since 1993.”

— Diane Coyle, “G.D.P.: A Brief But Affectionate History” (2014)

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