The Federal Reserve is on track to raise its benchmark interest rate by 0.75 percentage points at its meeting later this month as a result of another significant increase in consumer prices last month.
The Fed increased rates in June, the biggest increase since 1994, bringing the benchmark rate to a range of 1.5 percent to 1.75 percent. The urgency to quickly raise rates to levels high enough to slow the economy was already expressed by many Fed officials during their meeting on July 26–27, and the release of Wednesday’s report only emphasizes that point.
The Fed’s concern over consumers’ inflation expectations helps to explain why, even as it aggressively raises interest rates, it is paying closer attention to an inflation measure that includes volatile food and energy prices.
The Fed typically prefers to ignore changes in the food and energy categories and instead concentrate on measures of so-called core inflation, which exclude those erratic items. In June compared to a year earlier, Core CPI increased 5.9 percent. Future inflation tends to be predicted more accurately by core inflation.
Officials are currently placing less emphasis on core readings due to worries that it is now more difficult to predict inflation in general. Additionally, they are particularly concerned that the psychology of inflation may be changing in a way that will encourage customers and businesses to keep accepting price increases. After carefully examining the experience of the 1970s, central bankers and economists are concerned that these expectations could become self-fulfilling, causing overall inflation, or “headline” inflation, to remain high.
People “experience headline inflation,” Fed President
said last month at a press conference. “They are unaware of what core is. the reason why? They have no justification. Expectations are thus seriously jeopardized by high headline inflation.
The Fed’s preferred inflation gauge is the personal-consumption expenditures price index from the Commerce Department. While the PCE index more accurately represents household spending as a whole, the CPI measures consumers’ out-of-pocket expenses. The Federal Reserve sets a target inflation rate of 2% annually.
The CPI typically runs a little bit higher than the PCE due to differences in how the two indices are constructed. But right now, the difference between the two is almost at its widest since 1981. This is partially due to rising housing and energy costs, which account for a larger portion of the CPI basket of goods.
Consumer prices increased 6.3 percent from a year ago in May, per the PCE index. After peaking at 5.3 percent over the 12 months ending in February, core PCE prices increased by 4.7 percent from a year earlier in May. The rate of core PCE inflation slowed to 4% annualized between February and May, which is the lowest four-month rate since March 2021.
However, Mr. Powell has stated that more broadly based relief is required by the central bank. In a May interview, he said, “Truthfully, this is not a time for tremendously nuanced readings of inflation.” “We need to see a convincing decrease in inflation. Before we see that, we won’t assume we’ve succeeded.
In response to intensifying price pressures, central banks around the world are rushing to raise interest rates. Prices have recently increased as a result of rising fuel costs and supply-chain disruptions brought on by Russia’s conflict with Ukraine. Such increases in the U.S. are pushing up inflation, which was already high due to the last year’s surge in demand brought on by the reopening of the economy and aggressive government stimulus.
According to textbooks on monetary policy, central banks shouldn’t respond to supply shocks if they anticipate that the rise or fall in the price of a good, like oil, will subside over time. When the European Central Bank raised interest rates in 2008 and 2011 in response to higher oil prices, it discovered that doing so could exacerbate the economic harm caused by the price shock.
Undoubtedly, if gasoline prices remain high but do not increase further, this will eventually result in lower annual inflation. “The main goal is to simply stop the upward trend in commodity prices. If it stabilized, the inflationary effects would disappear. The Fed governor stated, “We don’t need them to actually come back down.”
declared last week.
The Fed staff economists predicted that PCE inflation would reach 5% in December before falling to 2.4 % at the end of next year due to falling energy prices at their meeting last month.
However, Fed officials have recently stated that they are unable to raise rates more gradually due to worries that a number of shocks could result in a higher inflation environment. In Portugal last month, Mr. Powell said at a central banking forum, “There’s a clock running here.” Our responsibility is to literally stop that from happening, and we’ll do just that.
The president of the Cleveland Fed stated that high inflation “calls into question the conventional view that monetary policy should always look through supply shocks.”
last month at the same conference. Such shocks “could pose a threat to the stability of inflation expectations in some situations and would necessitate policy action.”
Some economists are concerned that the central bank will raise interest rates excessively as a result of Mr. Powell’s focus on headline inflation, which would unnecessarily weaken the economy. This is due in part to the economists’ belief that workers won’t be able to negotiate for higher pay, even though inflation expectations are rising.
Another issue is that while monetary policy can’t easily affect the prices of food and gasoline without sparking a recession, expectations for near-term inflation tend to rise and fall with those prices.
When a lawmaker questioned whether high gas prices would ensure an aggressive response from the Fed, Mr. Powell conceded that point at a congressional hearing last month, but he referred back to concerns about higher inflation expectations.
Gas and food prices, for the most part, “add a little bit of urgency in our wanting to get our rates into a place where we’re addressing inflation directly, even though these things are outside of our control,” he said.