Prior to the August updates of both the Consumer and Producer Price Indices (CPI & PPI), futures markets were already predicting another 75-bps hike at the Federal Reserve’s September meeting, in part set up by a robust August jobs report and recent statements by FOMC officials. After a higher than expected 8.3% annual CPI reading in August, prophecy will likely become fate.
In the background of the committee’s policy decisions has been a growing debate about what the Fed can and should do. While there is a broad consensus that taming inflation is, and should be, a high priority, some argue that rate hikes have not been aggressive enough. Meanwhile, others are concerned that aggressive tightening could come at the expense of one of the strongest labor markets in decades.
While this debate plays out, the Federal Reserve has sent some clear signals about which risk it is willing to take on. References to the labor market have largely taken a backseat in FOMC press releases and public statements in recent months, while officials have intensified their rhetoric in an effort to anchor future policy expectations. In a September 7th interview with CNBC, Fed Vice Chair Lael Brainard proclaimed that ”we are in this for as long as it takes” in the fight against inflation, adding to a chorus of increasingly hawkish statements from Fed officials recently.
The central bank's disposition here points to a fight not only against inflation but against public doubt in its ability to conduct effective monetary policy. Fed officials are keenly aware that they have made errors over the past couple of years, causing a few sudden course corrections. From a risk to the Fed’s credibility standpoint, the question of whether to risk over-tightening or under-tightening is likely an easy assessment for Central Bank. After months of signaling that they are determined to bring down inflation, even at the cost of economic growth— If the Fed does too much, they are just doing what they told us they might have to. However, it significantly undercuts their credibility if they do too little and inflation rages on.
While short-term monetary policy is in front-of-mind for investors and the public, protecting their long-term ability to influence financial markets means they will favor being too hawkish over too dovish. It should come as little surprise then that markets reacted pessimistically to the August CPI numbers, despite a 75-bps hike largely being priced in beforehand.
Still, there is a separate third risk at play— what if monetary policy alone cannot bring inflation down?
Part of this concern stems from the debate around identifying the
leading cause of today's unrelenting price pressures. High inflation isn't just a domestic issue; it's a global one—which supports the reasoning that pandemic-induced supply chain and labor market disruptions are a foundational cause. If supply constraints are the main culprit, then monetary policy could have little impact since policy tools target demand factors rather than supply ones. Further, the War in Ukraine has added even more fuel to the fire, as global food and energy prices skyrocket in reaction to both supply shortages and Western economic sanctions. Domestic gas prices have fallen in recent weeks, but the fact remains that policymakers have little-to-no impact on food or energy price levels, which are top-of-mind concerns to the public.
However, the inflationary story is far more complex than global supply chain issues. A recent analysis by The Federal Reserve of San Francisco found that core inflation in the United States grew sooner and more quickly in 2021 than the OCED nation average.
In their analysis, the authors help explain excess inflation in the US by pointing to another common culprit— a boom in consumer demand that was kicked into gear by federal stimulus efforts. Suppose the excess inflation experienced by the US is indeed demand-driven rather than supply-driven; it would be reasonable to expect Fed tightening to have at least a moderate impact on price pressures. Still, if excess demand was caused by fiscal stimulus, there is reasonable suspicion that it cannot be tamed through monetary tightening alone.
Helping officials is some evidence that tightening is working. Since April, the first full month this year where interest rates stood above 25 bps, month-over-month inflation (core-PCE) has fallen to an average of 4.7% per month compared to an average of 5.1% in the four months prior (though core-CPI in August was just 20 bps below its March rate). Further, while housing prices remain elevated, homebuying demand has declined significantly. New home sales in July alone cratered by 12.6% month-over-month, reaching their lowest level since 2016. Still, over the same period, we have seen global supply chain pressure fall and commodities prices swing from a year-to-date peak in May before swinging back towards pre-pandemic levels—with just a tepid deceleration in consumer spending. Both factors fall outside of the scope of the Fed’s impact, challenging the assumption that monetary policy is the driving force of decelerating inflation.
One thing is for sure—the Fed is pushing forward with its plans, as it should since pivoting could be devastating to its ability to influence markets in the future. Nonetheless, they may be getting some aid from supply-side forces bending towards their goal while continuing to feel a thorn in their side from Vladimir Putin's Ukraine ambitions. Only time will tell if their approach is the right one.