August 2023 inflation data look good enough for the Federal Reserve to declare victory against inflation. But that surface observation most likely masks substantial trouble yet to come. And the Fed itself will likely treat the numbers as highly provisional.
News headlines feature the Consumer Price Index, but the Fed likes to watch another measure, the Personal Consumption Expenditures Price Index Excluding Food and Energy. Over the past three months, that index has grown at an annualized rate of only 2.2%. That’s just a hair above the Fed’s two percent target. If we were to hit 2.2% for a full year, the Fed would declare victory and Jerome Powell would be feted on Main Streets all across America.
My skeptical view is offered with the humility of a forecaster who has been wrong before, but the weight of evidence seems overwhelming. Recall the precursors of our inflation. Federal government spending soared in the pandemic and has not yet returned to its pre-pandemic trend line, much less its pre-pandemic level. At the same time the Fed flooded the economy with liquidity, pushing the money supply up 40% above its pre-pandemic level. Even after the Fed’s tightening the money supply sits 35% above the February 2020 level.
This grand stimulus came without any increase in the nation’s productive capacity. In fact, labor supply dropped due to early retirement during the pandemic, along with the need to care for children and fear of Covid. Labor supply has improved lately, but not by enough to bring us back to the pre-pandemic trend line.
Although many supply chain problems have resolved, oil is still priced high because of the Ukraine-Russian war and the OPEC+ supply limitations. The Fed looks at inflation measures stripped of energy, but some fuel costs bleed through anyway. Higher diesel prices mean delivery cost inflation even of non-energy products.
Through the summer of 2023 the real side of the economy—employment, production and inflation-adjusted spending—has suffered little from higher interest rates.
So why did inflation drop in the three latest months of data? The series is erratic. No economic statistic is measured perfectly. The PCE inflation measure is built up from data collected by the U.S. Bureau of Labor Statistics for the Consumer Price Index. Then the inflation index is calculated using a better methodology. Still, the underlying data emphasize traditional products, mostly sold in traditional stores. The methods do not perfectly measure changes in quality of products, nor perfectly measure bundled products.
Statistical anomalies get accentuated when looking at three-month changes that are annualized. Take the relatively stable inflation of 2005. The core PCE measure calculated over 12 months ranged from 2.1% to 2.3%. But the 3-month annualized figure had a low of 1.2% and a high of 2.9%. In these more volatile times, the 3-month measure is probably even less accurate as a measure of the long-run inflation trend.
Business leaders should thus take the recent good news on inflation with some skepticism. Still, it is possible that we are farther along in the fight against inflation than I think. Thus, companies may not be able to pass large price increases on to customers, and they may not need to grant large pay raises to retain workers. The Fed might possibly bring interest rates down starting in a few months. Even though I think this path unlikely, some contingency planning for that possibility makes sense. In fact, even if premature, that sort of thinking will be useful at some point in the coming years. It will not be a waste of time to do it now.
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