By Raphael Bostic, President and Chief Executive Officer
June 27, 2024
Since my last essay in March, the economy and labor markets have continued to expand healthily. But the outlook on the most pressing issue of the day – inflation – has taken a subtle turn.
First, let me provide a quick overview.
During 2023, the inflation rate fell by more than half—from well above 5 percent to below 3 percent, for the personal consumption expenditures (PCE) price index, the Federal Open Market Committee’s (FOMC) preferred gauge. . This was a much larger decline than my staff, myself and most observers expected.
However, this progress slowed significantly earlier this year, with some suggesting that the decline may have stalled entirely.
Well, the latest inflation reports provide signals that push against the “stagnation” narrative. The April reports on the consumer price indices and PCE presented an inflation picture that was more consistent with data taken in the second half of 2023 than what we saw in the first months of 2024. In April, the year-over-year headline The PCE reading of 2.7 percent was the same as the November 2023 reading.
Although April’s PCE inflation reading was unchanged from five months ago, digging into the details of the inflation reports reveals some promising signals. One that I pay attention to is the breadth of price changes—specifically, the percentage of prices of individual goods and services in the consumer price index that rose more than 5 percent. That share reached 18 percent in May and the three-month average has fallen to 35 percent, a level not seen since the summer of 2023, when headline inflation was falling sharply.
However, this figure of 35 percent is higher than a level that is consistent with price stability. But the main point is that it is moving in the right direction. Consider that two years ago, in May 2022, 70 percent of prices increased by 5 percent or more. So price pressures appear to be narrowing.
Progress will continue, but patience is needed
Despite those hopeful tremors of late, the stubbornness of inflation earlier this year indicates that progress toward the FOMC’s 2 percent target is likely to come more slowly than I and others had previously hoped. That said, I have long maintained that the road to 2 percent would take considerable time; it just might take a little longer than expected, given how quickly inflation was falling as we exited 2023.
If conditions develop as I expect — a steady slowdown in the labor market and economic activity — then inflation should fall to 2 percent in 2025 or perhaps a little later.
Although 2 percent is the undisputed target, it is important to note that inflation does not have to reach the target for me to favor loosening the constraints on monetary policy. If the Committee waits that long, it risks severely damaging the momentum from the economy and the labor market and creating unnecessary and harsh disruptions.
Instead of holding the federal funds rate steady until we are IN target, I would favor lowering the policy rate once I gain additional confidence that we are clearly on track to the 2 percent target.
What would provide this confidence? I am particularly looking for progress in shelter prices and utility prices more broadly. Prices of services—air tickets, restaurant meals, hotel rooms, haircuts, oil changes—tend to move much less quickly than commodity prices because the largest input cost in service prices is usually labor. and wages do not tend to move as quickly as commodity prices therefore. But recently, contacts in the service industries are telling me and my staff that their pricing power is eroding a bit, meaning they’re finding it harder to raise prices without scaring away customers.
Home prices and rents, meanwhile, have fallen more slowly than expected amid the Committee’s moves to raise the federal funds rate from zero to above 5 percent over 16 months. My research team tells me that declines in market rents will eventually show up in official price data, but that development has been slow in coming.
Like many economic dynamics in the wake of the pandemic, housing prices have behaved differently in this inflationary episode than history suggests. Economists at our Bank and elsewhere are working to clarify the reasons why.
I will also look beyond the headline numbers. As for inflation, I would like to see a narrowing of the range of price changes I mentioned above. To use a labor market example, we will track the extent to which high employment growth numbers continue to be a function of strength in a small number of sectors—in health care and government, in particular—or will represent strength in a broader set of sectors suggesting a slowdown may not be imminent. Overall, as a general matter, I want to make sure that we achieve a price stability that will continue beyond the initial achievement of a numerical headline of 2 percent.
The pandemic is still a major economic impact
One reason I will look beyond the headlines is that it is clear to me that, despite a return to normalcy in many areas of our lives, today’s economy is still heavily impacted by the global pandemic. I think the effects of political responses to the pandemic have strengthened the labor market and the broader economy, even in the face of aggressive monetary policy tightening.
Monetary policy first affects the economic sectors most sensitive to interest rates, as might be expected. Prominent among these sectors is housing. And mortgage bankers tell me they’ve basically been in recession for a year because prevailing mortgage rates quickly doubled or tripled to levels above 7 percent.
However, across the economy, activity has continued despite higher interest rates. For many months during the lockdowns, most of us were limited in what we could spend money on. The financial support also left many families in a stronger financial position than they had been at the start of the pandemic.
All along, in the years immediately preceding the pandemic, interest rates had been low by historical standards. As a result, many consumers and firms locked themselves into low rates for long-term credit, and then did so when the Fed cut rates at the start of the pandemic lockdowns to support economic activity. These dynamics, in my opinion, have softened the impact of higher interest rates.
Other changes may also change the way restrictive policy affects the economy. Looking ahead, business contacts tell me and my staff that a large emerging category of capital spending is software-as-a-service. Basically, instead of buying software packages, companies pay an ongoing monthly or annual fee to use applications hosted in the cloud. This type of transaction usually does not involve borrowing, and thus is likely to be hindered by higher interest rates.
The result of these and other factors is that it may take longer for stricter policies to drive business decisions in a material way.
But we see signs that this is starting to happen. Gross domestic product (GDP) growth in the first quarter slowed to just over 1 percent, after reaching 3 percent in the third and fourth quarters of 2023. And, although 272,000 new jobs in May were a positive surprise, the reports I’m hearing from the Sixth District business contacts give me confidence that a slowdown is also happening in the labor markets. Hiring is lighter, turnover is down, and broader measures of the labor market, such as the Kansas City Fed’s indicators of labor market conditions, report that market activity has fallen sharply since the start of the year. One might think of labor markets today as “liberating but not free.”
On balance, I believe the latest GDP and employment numbers depict a steady slowdown in activity that will restore balance between supply and demand in the economy. This realignment should, in turn, exert downward pressure on prices. Ultimately, excess demand over supply fueled rising inflation starting in 2021.
It’s really Econ 101: the combination of the demand for a good or service and its supply determines the price. This applies not only to cars or carpenters, but also to the economy.
All things considered, I continue to believe that conditions will likely call for a cut in the federal funds rate in the fourth quarter of this year. However, the pandemic years have brought many surprises, and so I am not locked into any particular political path. There are plausible scenarios in which more layoffs, no layoffs, or even a raise may be appropriate. I will let the data and field conditions be my guide.
Be sure that we will bring inflation to 2 percent. This is the Committee’s definition of price stability, a necessary condition for broad prosperity, sound decision-making for households and firms, and an economy that works for everyone.
When we get inflation to 2 percent, it doesn’t mean that prices will generally be lower than they were before 2021. What it means is that we should have an economy in which inflation does not dominate more the psychology of consumers and producers, and this is the state which the Committee and I aim to achieve.
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