Why the Fed Isn’t Ready to Declare Victory on Inflation

Uncertainty over the path of inflation later this summer makes it hard to predict the Federal Reserve’s next steps following a likely quarter-percentage point increase in interest rates this week.

Some Fed policy makers and economists are concerned that the easing in inflation will be temporary. They see inflation’s slowdown as long overdue after the fading of pandemic-related shocks that pushed up rents and the prices of transportation and cars. And they worry underlying price pressures could persist, requiring the Fed to lift rates higher and hold them there for longer.

Other economists say that thinking ignores signs of current economic slowing that will gradually subdue price pressures. They also argue inflation will slow enough to push “real” or inflation-adjusted interest rates higher in the coming months. That would provide additional monetary restraint even if this week’s rate increase is the last of the current tightening cycle.

The Fed last month held its benchmark federal-funds rate steady in a range between 5% and 5.25%, its first pause after 10 consecutive increases since March 2022, when officials raised it from near zero.

Interest-rate increases slow the economy through financial markets by lowering asset prices and raising the cost of borrowing.

Inflation cooled last month to its slowest pace in two years. The consumer-price index climbed 3% in June from a year earlier, sharply below the recent peak of 9.1% in June 2022. The index for core inflation, which excludes volatile food and energy prices, in June also posted its smallest monthly increase in more than two years.

“While things seem to be heading in the right direction with inflation, we are only at the start of a long process,” said Karen Dynan, an economist at Harvard University.

Playing catch-up on inflation-adjusted pay growth

The first camp of economists is nervous that there is too little slack and too much demand in the economy to be reasonably confident that inflation will return to the Fed’s 2% inflation target in the coming years. They don’t share investors’ recent optimism that inflation can sustainably ease without a broader economic slowdown, though they concede coming data could bolster hopes the Fed can achieve a so-called soft landing, where it contains price pressures without putting the economy in recession.

Many of these economists worry that wage growth is too strong. Without a recession, they see a tight labor market pushing up core inflation next year.

Since an overheated labor market is likely to show up first in wages, many see pay gains as a good proxy of underlying inflation pressure.

Officials are likely to see 3.5% annual wage growth as consistent with inflation between 2% and 2.5%, assuming productivity grows around 1% to 1.5% a year. 

Wages and salaries rose 5% in the January-to-March period from a year earlier, according to the Labor Department’s employment-cost index. The Fed closely watches the index because it is the most comprehensive measure of wage growth. The second-quarter figure is to be released on July 28.

Top-down versus bottom-up

A big question is whether workers in a tight labor market will accept minimal inflation-adjusted wage gains following two years in which their pay didn’t keep up with inflation. 

“Most people being told they’re getting a 3.5% wage increase for the next year are going to at least think about, ‘Could I get a higher wage if I go somewhere else?’” said Eric Rosengren, former president of the Boston Fed.

A related concern: Many investors’ optimistic analysis of inflation—a bottom-up view that emphasizes impending declines in used-car prices and a sharp slowdown in rents—have yielded poor forecasts in recent years.

Two years ago, economists thought idiosyncratic and sharp price increases would quickly reverse, which led them to overlook strong underlying demand, Dynan said.

“The experience of 2021 was a powerful reminder of the risk of focusing on special stories rather than deeper underlying forces,” she said. “You still have to go back to the big picture and recognize that there’s a lot of underlying momentum today.”

A traditional top-down analysis of the economy could argue for falling inflation in some price categories to reduce pressure on disposable income, fueling demand and creating more inflationary pressure, said Seth Carpenter, chief global economist at Morgan Stanley.

Some signs of labor markets loosening

The second camp of economists believe there is ample evidence that the labor market is cooling, in turn taking pressure off inflation. 

The amount of time it is taking unemployed workers to find new work has been growing. Increases in hours worked by private-sector employees has slowed along with the number of unfilled jobs. “This is pointing to a labor market that is really slowing in earnest,” said Jonathan Pingle, chief U.S. economist at UBS.

Monthly private-sector hiring eased to an average 215,000 jobs during the first half of this year, down from 317,000 in the second half of 2022 and 436,000 in the first half of 2022. “There was a greater imbalance in the labor market than appreciated, and it’s taking longer to work it off. But we are working it off,” said Brian Sack, an economist and former senior executive at the New York Fed.

If the job market continues to add 200,000 positions a month, “that’s license for the Fed to stay higher for even longer,” said Pingle, referring to the level for interest rates. But if job growth continues to slow at the same time that lower inflation pushes up real rates, “they are going to face a sharper trade-off about just how restrictive they want to be.”

In June, Fed officials projected they would need two more quarter-point rate rises from current levels, up from no additional increases projected in March. They also anticipated a more muted fall in inflation this year.

“The view that we would need two additional rate hikes rested in part on their frustration that inflation had not moderated more substantially. That’s now changing,” said Sack. “The rate hike this week is more strongly justified by the robustness of growth and hiring than the incoming data on inflation.”

Officials can debate whether that second move is necessary if inflation and economic activity continue to slow. “The encouraging news about inflation is creating space for the Fed to be more patient and take their time,” Dynan said.

Write to Nick Timiraos at [email protected]