By now, we can all agree that inflation has gone higher and lasted longer than most, including the Federal Reserve itself, thought it would. Inflation, as measured by the Consumer Price Index (CPI), was up 8.6% in May, compared to a year prior. The Fed's preferred inflation measure—Core CPI, which excludes food and energy—was up 6%, way over the Fed's 2% target.
As a result of the ongoing inflation, the Fed has gone from a patient, slow and steady approach to rate hikes and balance sheet reduction, to trying to figure out how quickly to tighten monetary policy without driving our economy into a recession.
Goods prices remain high, despite shift in consumer spending
Looking back, we went into 2022 expecting the Fed to raise interest rates twice—three times at the most—because we thought shifts in consumer spending would drive the price of goods down. During the COVID-19 pandemic, consumers tended to spend money on goods, like home appliances, rather than services like travel, entertainment and restaurants. As restaurants and other services continued to reopen, we expected consumers to spend more money on those services and less on goods. That shift in consumer spending has occurred, resulting in higher prices of services like airfare, which increased by 12.6% in May after a record 18.6% in April. Yet at the same time, unforeseen events like the conflict between Russia and Ukraine, the extension of China's zero-tolerance COVID policy and ongoing supply chain issues have kept the prices of goods high as well. Food prices, for instance, were up 10.1% in May, compared to a year prior, while gasoline was up by a whopping 48.7%.
Meanwhile, wages have risen but haven't been able to keep up with inflation. In fact, when adjusted for inflation, wages have been declining. Real average hourly earnings dropped to $10.96 in May, compared to $11.30 a year before. Workers in the lower half of earners are being hit the hardest, as they have to spend greater portions of their income on food and gas. Those who rent also have been feeling the pinch. Asking rent was up 15% year-over-year in April, which was a slight decline from March's 17% YoY increase, but the first decline in over a year. That slight slowdown might be an early positive sign for renters. Nevertheless, given the long-term nature of leases, it might be some time before we see rent come down, even as overall economic activity slows.
The Fed remains way behind inflation
Amid all this, the Fed's actions haven't been as aggressive in their response to inflation as their communications have been. So far this year, the Fed has only raised rates by 1.50%—and announced "quantitative tightening," that is, allowing Treasury and mortgage bonds to mature without replacing them.
As it is now, the federal funds rate likely will be near 3.5% by the end of the year; however, there is the chance that the Fed will have to become more aggressive. If the war in Ukraine continues or China makes a move on Taiwan, longer-term inflation expectations could rise significantly and result in a wage-price spiral. Then, inflation would turn into a much bigger problem than it is now. To combat it, the Fed could have to raise the federal funds rate to as high as 4.5% by year-end, which currently isn't factored into stock market expectations. That's not our base case, but it is a possibility.
Communication will be key
Although there are many factors, like the war in Ukraine, that are outside the Fed's control, the bottom line is that the Fed will have to be very clear in communicating what they're trying to do so that they don't surprise the markets. The cure for inflation is to slow the economy, and they do need to let the job market, in particular, cool a bit. That puts the Fed into an interesting conundrum on how to fulfill their dual mandate of price stability and maximizing employment. To do one, they might have to back off a bit on the other.