The Federal Reserve maintains strict rules prohibiting FOMC members from commenting on the economic outlook or monetary policy in the 10 days preceding an FOMC meeting or on the following day. Thereafter they are free to speak and over the last two weeks many have opined on both subjects. Their opinions show remarkable unanimity. They are focused on bringing inflation back down to their 2% target. They acknowledge the uncertainty in the economic outlook, and, as a consequence, they profess themselves to be “data dependent” and frequently quote, with furrowed brows, the year-over-year increases in CPI and consumption deflator measures of inflation.
However, data dependency can be carried too far. Monetary policy impacts the economy with a lag. So, for that matter, do fiscal policy and exchange rates. Any turn in year-over-year inflation rates, will, by definition, lag a monthly change in seasonally adjusted inflation momentum. In the long history of Federal Reserve mistakes, one general error stands out. They tend to wait too long and then do too much, and, in so doing, actually accentuate rather than tame the business cycle.
They appear to be well on their way to repeating this error today. If they do so, they could inflict an unnecessary recession on American families, while doing little to improve productivity or living standards. That being said, however, such a recession would most likely be shallow and would give way to an environment of slow growth, low inflation, low interest rates and high profit margins—in short, a very positive environment for both bonds and stocks.
The Short-Term Inflation Outlook
On Thursday, the Bureau of Labor Statistics will release the consumer price index numbers for September. We expect a 0.3% increase overall with the seasonally adjusted year-over-year headline rate falling from 8.2% to 8.1%. Excluding food and energy, we are looking for a 0.4% increase with the year-over-year rate rising from 6.3% to 6.5%.
While this would represent a continued slow drift down in headline inflation from its June peak of 9.0% year-over-year, both financial commentators and Fed officials are likely to declare this progress as being too slow. In addition, many will focus on the increase in year-over-year core CPI inflation to its highest level in the current cycle, surpassing its March reading of 6.4%.
However, beneath the surface there are plenty of signs of short-term progress. Food commodity prices, while up sharply year-over-year, have backed off from their springtime peak. Crude oil prices, despite last week’s OPEC production cut, are well below their mid-summer peak as are U.S. natural gas prices. In addition, wholesale used car prices and airline fares have fallen recently and a rebound in new car inventories, from very low levels, should relieve some pressure in this area also.
If we assume that a September headline CPI monthly increase of 0.3% is repeated over the following three months, then year-over-year headline CPI inflation will be below 7.0% by December.
Core CPI inflation may fall more slowly, from 6.5% year-over-year in September to 5.4% year-over-year in December. However, it must be emphasized that shelter accounts for almost 42% of core CPI and the owners’ equivalent rent part of this accounts for more than 30% of core CPI on its own. This is important for two reasons.
First, both actual rent and owners’ equivalent rent lag the rest of CPI very significantly as they track the increase in rental costs for both new and existing leases. Even when new lease rates begin to fall, the year-over-year change in existing lease rates can remain positive. Recent research by the Dallas Federal Reserve suggests that the year-over-year increase in both actual rent and owners’ equivalent rent won’t peak until the middle of 2023 at levels of close to 8% year-over-year.
Second, it is very doubtful whether the Fed should use this kind of inflation as a guide for monetary policy. Owners’ equivalent rent is an entirely nebulous concept. It is the rent homeowners would pay if they rented rather than owned their home. But since homeowners do own their homes, no economic harm is caused by rising owners’ equivalent rent.