For over a year now, economic-policy commentators have debated what to do about inflation. With prices rising faster than they have in four decades, consumers and politicians alike were not happy (though many corporations have been raking in fat profits). In response, the Federal Reserve has been hiking interest rates at a frenzied pace.
The debate has two basic poles. On the one hand, as my colleague Robert Kuttner outlines, hawks like Larry Summers have held that only a vicious economic pummeling of the working class will do the job—five years of unemployment above 5 percent in his view. On the other, “Team Transitory” has held that the inflation is largely caused by one-off factors—supply chain disruptions, Putin’s war in Ukraine, and pandemic relief money that is now far in the rearview mirror—as well as deregulation and corporate consolidation, which ought to be addressed with policy changes rather than unemployment.
For a time, it seemed the transitory school (including myself, admittedly) had underestimated things. But the most recent Consumer Price Index (CPI) report, released yesterday, shows a marked softening in inflation—and when we peer into the entrails of the data, there are strong indications that this trend will continue in the near future. The Fed has every reason to stand pat on rate hikes, or at least moderate the pace of increases.
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The new CPI figure is for November, and it shows a 7.1 percent increase on a year-over-year basis. Core inflation, which excludes volatile food and energy prices, is up just 6 percent. That’s both the second consecutive monthly slowdown and lower than what economists had predicted. Stocks soared on the news.
Even more promising was data showing that rents look to be peaking in many markets, that the previous huge surge in the price of services is coming down, and that many goods are actually falling in price—particularly cars, which had hitherto been a major inflationary driver. “This is exactly the inflation print I had been hoping for,” Mike Konczal, director of macroeconomic analysis at the Roosevelt Institute, told the Prospect. “The three trends we all want to see—the price of goods actually coming down, services starting to cool, and the government numbers peaking on housing—are all here, and for the second month in a row.”
The case for Fed restraint is strengthened when we take into account how slowly interest rates work as a policy mechanism. Their biggest effect is on housing—by making it much more expensive to borrow, the costs of construction and mortgages are increased. Sure enough, we’ve seen a major slowdown in new housing starts and in demand for single-family homes. That crashes the construction industry, which reduces spending in sectors that depend on construction spending, and so on. That effect can take months or even years to fully work itself out, as compared to the sizable month-by-month movements we’re seeing today.
Indeed, as economist Alex Williams argues at Employ America, there’s a plausible case that even the peaking rents we’re seeing don’t have very much to do with the Fed’s rate hikes. Real-time rent measurements from sources aside from the CPI (which compares costs to the previous year’s) showed a rent inflation peak before the Fed started hiking. That points to other causes: For instance, we know that strong job growth causes rent increases, and the past two years have seen some of the largest new employment numbers in American history. We also know that thanks to the rise of work-from-home in many industries, millions of people moved out of hyper-expensive places like San Francisco and New York City and into relatively cheaper cities in the hinterland.
The case for Fed restraint is strengthened when we take into account how slowly interest rates work as a policy mechanism.
But both of those processes are now largely completed. Job growth has slowed dramatically as the economy nears the level of employment we saw before the pandemic. Work-from-home seems to be settling down into a stable pattern. “Allowing the recovery to run its course—rather than continuing to hike until we see a recession—may accomplish the Fed’s anti-inflationary goals just as well as continued hikes would, but without risking economic growth and employment,” Williams writes.
Given how comparatively quickly inflation seems to be coming down, and the dubious (at best) connection between the Fed’s interest rate mechanism and the drivers of inflation, the Fed would be wise to cool it on rate hikes. Another few super-aggressive 0.75 percent moves and this time next year we could be in a deflationary recession with the Fed ineffectually trying to reverse course as it did during the 2010s—with no prospect of fiscal policy coming to the rescue.
As a closing comment, it’s truly remarkable how well the U.S. economy has held up this year. It shrugged off numerous body blows—inflation, tremendous supply disruptions, and a central bank leaning on the recession button. And despite it all, we haven’t seen this kind of hot labor market and powerful consumer demand for decades. If there’s any chance of preserving this situation, the Fed is obligated to try.
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