Decline in Inflation So Far: (A review)

  1. Origins and Initial Actions:

    • High inflation resulted from strong demand meeting pandemic-limited supply.
    • The Federal Open Market Committee raised the policy rate in March 2022 to address inflation.
    • The goal was to slow demand growth, allowing supply to catch up.

  2. Headline PCE Inflation:

    • Peaked at 7% in June 2022, then declined to 3.3% by July 2022.
    • Global events, like Russia's war against Ukraine, influenced these changes.
    • Headline inflation reflects the direct experience of households and businesses.

  3. Core PCE Inflation:

    • Excludes volatile food and energy prices.
    • Peaked at 5.4% in February 2022, then decreased to 4.3% by July.
    • Two months of positive data is just the start; more is needed to ensure sustainable decline.
    • The goal is to achieve price stability.

  4. Core Goods Inflation:

    • Has seen a significant decline, especially for durable goods.
    • The motor vehicle sector exemplifies this trend, with prices spiking during the pandemic due to demand-supply imbalances.
    • As the pandemic's effects lessen, supply improves, and demand decreases due to higher interest rates.
    • Restrictive monetary policy is essential for continued progress.

  5. Housing Sector Inflation:

    • Interest rates greatly influence this sector.
    • Mortgage rates doubled in 2022, leading to decreased housing starts, sales, and house price growth.
    • Growth in market rents began to decline.
    • Measured housing services inflation, reflecting all rents, has started to decrease but lags behind market changes.

  6. Nonhousing Services Inflation:

    • Makes up over half of the core PCE index.
    • Includes services like health care, food services, and transportation.
    • Inflation in this sector remained stable since liftoff but has shown a decline over the past three to six months.
    • This sector is less affected by global supply chain issues and is less sensitive to interest changes.
    • The labor-intensive nature of these services and a tight labor market have influenced inflation here.
    • Restrictive monetary policy will be crucial for balancing supply and demand, reducing inflation in this sector.

Outlook: (A look ahead)

  1. General Perspective:

    • The unwinding of pandemic-related distortions will continue to reduce inflation, but restrictive monetary policy will play a significant role.
    • Achieving a 2% inflation rate will likely need a period of economic growth below the trend and some relaxation in labor market conditions.

  2. Economic Growth:

    • Restrictive monetary policy has led to tighter financial conditions, pointing to growth below the trend.
    • Real yields have increased, bank lending standards have become stricter, and loan growth has decelerated.
    • Indicators like slowed industrial production growth and reduced residential investment expenditure suggest a slowing economy.
    • However, there are signs that the economy might not be cooling as anticipated, with GDP growth exceeding expectations and consumer spending being particularly strong.
    • A resurgence in the housing sector and consistent above-trend growth might necessitate further monetary policy tightening.

  3. The Labor Market:

    • The labor market has been rebalancing over the past year, but the process isn't complete.
    • Labor supply has improved due to increased participation from workers aged 25-54 and a return to pre-pandemic immigration levels.
    • The labor force participation rate for prime-aged women reached a record high in June.
    • Although job openings remain high, they are decreasing, and payroll job growth has significantly slowed.
    • Total hours worked have remained stable, and the average workweek has returned to pre-pandemic levels, indicating a normalization in labor market conditions.
    • Wage pressures have reduced, with wage growth slowing across various measures. However, real wage growth has been on the rise as inflation decreases.
    • The expectation is for the labor market rebalancing to persist. If labor market tightness doesn't ease, it might necessitate a monetary policy intervention.

Uncertainty and Risk Management along the Path Forward: (the Challenges)

  1. Inflation Target Commitment:

    • The inflation target is set at 2%.
    • The goal is to establish a monetary policy that is restrictive enough to reduce inflation to this target over time.
    • Determining when this stance is achieved in real-time is challenging.

  2. Real Interest Rates and Policy Stance:

    • Real interest rates are currently positive and exceed mainstream estimates of the neutral policy rate.
    • The current policy is seen as restrictive, exerting downward pressure on economic activity, hiring, and inflation.
    • The exact neutral rate of interest is uncertain, leading to ambiguity about the precise level of monetary policy restraint.

  3. Lags in Monetary Tightening Effects:

    • The effects of monetary tightening on economic activity and inflation are delayed.
    • Over the past year, the policy rate has been raised by 300 basis points, with a 100 basis point increase in the last seven months.
    • The size of securities holdings has also been significantly reduced.
    • The varied estimates of these delays suggest potential further impacts.

  4. Supply and Demand Dislocations:

    • This cycle's unique supply and demand imbalances complicate the effects on inflation and labor market dynamics.
    • Job openings have decreased without a corresponding rise in unemployment, indicating a significant demand for labor.
    • Inflation appears to be more sensitive to labor market tightness than in recent decades.
    • It's uncertain whether these dynamics will continue, emphasizing the need for flexible policymaking.

  5. Balancing Risks:

    • Policymakers face the challenge of weighing the risk of over-tightening monetary policy against under-tightening.
    • Insufficient tightening could lead to persistent above-target inflation, necessitating more aggressive measures that could harm employment.
    • Over-tightening could also damage the economy unnecessarily.

There has not been a great move in Fed pricing. However, there is a dovish response to the speech despite the Fed Chairs insistence that the inflation still needs to come down and the economy remains strong with GDP.