"Good Cheer" On Inflation: Is the Slowdown Sustainable or Does The Fed Need To Do More?
Core consumer price inflation slowed in October, triggering investors' loud "good cheer" about the prospect of smaller official rate hikes and possibly ending the rate hiking cycle before long. The news on consumer inflation is a welcome development, but is it sustainable? And how does the Fed view the slowdown in inflation when the running rate of inflation is far above the Fed's target?
In October, consumer price inflation rose 0.4% and the core rate 0.3%, resulting in 7.8% and 6.3% year-on-year gains, respectively. The monthly increase in core prices matches the low readings of the year, which happened in March and July; the latter also triggered a significant equity market rally until Fed Powell's Jackhole speech squashed it.
Inflation cycles are uneven, and the month-to-month composition of inflation reports differs significantly. In October, core goods prices declined by 0.4%, while core services rose by 0.5%. Core goods prices registered a similar decline last March, followed by monthly gains. Yet, this decline looks different, reflecting softer demand and higher inventory levels for some products.
But core service prices are driven more by labor costs. As long the labor market remains strong and job vacancies far outweigh the unemployed, service prices will continue to increase. And service prices account for roughly seventy percent of the core price index.
So the "good news" on inflation, even with the recent decline in goods prices, leaves the Fed far away from its ultimate goal. That's because the underlying core inflation rate of 0.3% (i.e., 4% annualized when compounded) is twice the Fed's target of 2%.
So the Fed must keep lifting official rates modestly to its previously stated targets to keep downward pressure on goods prices and weigh the possibility of going much higher than previously thought so core service price inflation slows.
The fight against inflation is not won or accomplished in a month or two. Policymakers have made numerous mistakes, which would compound their errors if they took their foot off the peddle, as that would allow inflation to settle in at a higher trend rate than it wants. The giddiness of equity investors could also play a role in Fed's policy decisions since rising equity prices could reignite consumer demand and risk-taking. From my vantage point, the Fed funds rate needs to hit 5% or higher in the coming months.