The Fed Still Doesn’t Get It; Inflation Will Stay High Next Year

Despite its 75 basis point rate hike, the Federal Reserve still doesn’t understand inflation. As a result, Americans will continue to see high inflation for a couple of years, and the Fed will end up pushing interest rates even higher than it currently expects.

The 75 basis point interest rate hike announced June 15 was a good change from older, more gradual policies. The decision to shrink the Fed’s balance sheet was another step in the right direction. And the policy-making committee said the right words: “The Committee is strongly committed to returning inflation to its 2 percent objective.” (See note below for more information about the committee.)

But the future expectations for inflation and policy show that the Fed doesn’t get it. They misunderstand the dynamics of inflation and especially how long it takes for monetary policy to affect inflation.

Because supply problems come and go erratically, the Fed watches “Core PCE Inflation,” which is the change in the Personal Consumption Expenditures price index excluding food and energy. That index rose by five percent in the last 12 months. The projections released with the decision show that committee members anticipate 4.3 percent inflation in 2022 (measured December to December). That’s in line with where we are so far. But next year the committee’s median projection is just 2.7 percent, a major deceleration. And that’s in a measure that strips out food and energy prices. (See note below regarding projections.)

If core inflation rose so sharply and then will fall so sharply, there has to be a reason beyond the Ukraine war. That’s what the Fed doesn’t get. They put huge stimulus into the economy in 2020 and 2021, with continuing stimulus through April 2022. Inflation did not jump right away, which is consistent with the many studies of time lags in monetary policy. As a rough rule of thumb, the time lag is about two years from cause (monetary policy) to effect (a change in inflation). The FRB/US economic model used by the Fed has a shorter time lag, just one year. (The time lags are more complicated that simply one year or two years.)

What will bring inflation down? Tighter monetary policy, operating with a lag. And in calculating the time of impact, keep in mind that the even after the Fed’s June announcement, short-term interest rates remain below inflation. Their shrinkage of the balance sheet has just begun. Best case, we’ll be seeing only the first signs of slowing inflation next summer. The 2.7 percent projection is highly unlikely.

The Fed’s inflation forecasting model contains a strong effect on inflation by inflation expectations. That is, if people think that inflation will remain low, then inflation will remain low absent other major changes. It’s certainly true that expectations impact inflation in the short run, but the Fed places a very high weight on expectations.

How are inflation expectations formed? The Fed believes that its own statements, forward guidance and credibility are hugely important. That is probably hubris, the overestimation of one’s own power that was regularly punished in Greek legends.

Most likely, inflation will still be excessive in the summer of 2023, leading the Fed to keep raising interest rates. Their current projections put short-term interest rates at 3.4 percent at the end of 2022 and 3.8 percent at the end of 2023. The 2022 figure is plausible, but the 2023 number wont’ get inflation down.

The time lags in monetary policy will keep inflation with us for another two years at least. The Fed’s ignoring the role of its past massive stimulus may also contribute to higher inflation in the next few years.

Note: Monetary policy is conducted primarily by the Federal Open Market Committee, consisting of the seven Federal Reserve governors and five of the12 regional Federal Reserve Bank presidents.

Note: Projections are submitted by all Federal Reserve governors and all of the 12 regional Federal Reserve Bank presidents. Figures cited in this article are the median projections.