Note to the Federal Reserve: Don’t Panic About Inflation

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The bad economic news this week is that inflation, as measured by the consumer price index, hit a 40-year high of 7.5% in January. The even worse news is that there is now a serious danger that the Federal Reserve will overreact and drag the economy into a recession by dramatically raising interest rates. Following the release of inflation data on Thursday, Wall Street is expecting a half-point hike in the federal funds rate at the next Fed meeting – the biggest increase since 2000. There is even had speculation that Jerome Powell and his colleagues might pass an emergency rate hike before then. James Bullard, president of the Federal Reserve Bank of St. Louis, said he and his colleagues should ensure the funds rate hits 1% by July. Goldman Sachs predicted the Fed would hike rates seven times this year.

This is all because the January inflation figure is a bit higher than expected, yes, a bit. Goldman, for example, predicted that the core inflation rate, which excludes volatile prices like energy and food, and which the Fed is watching closely, would jump 0.56% in January, for a annualized rate of 6.01%. The actual monthly figure was 0.58%, for an annualized rate of 6.02%. These differences are trivial.

Why be alarmed by such a small upside surprise? Inflation hawks point out that the CPI report indicated that the rise in prices, which was largely limited to physical goods, such as cars and furniture, is now spreading to the much larger services sector, which represents about three quarters of the economy. On Thursday, Tyler Goodspeed, an economist at the Hoover Institution who chaired the White House Council of Economic Advisers under Donald Trump, made that argument in an interview with Bloomberg. More broadly, many people – including Bullard – cited the inflation report as evidence that the central bank, having kept short-term interest rates close to zero since the start of the pandemic, is now desperately in behind and must act drastically to catch up. “That’s a lot of inflation in the United States,” Bullard said. “It surprised us. We have to design a policy to keep it under control.

The details of the inflation report provide some supporting evidence for these arguments, but also some less favorable evidence. The price of medical services increased by 0.6% last month, the cost of domestic services (such as cleaning) increased by 0.9% and the cost of haircuts and other personal care services jumped by 1 .2%. These are significant increases. However, taking the services sector as a whole (minus energy services), prices jumped 0.4% in January, compared to 0.3% in December and 0.4% in October. It doesn’t look like a sudden takeoff.

In the goods sector, where supply chain issues have hit hardest, there have been some signs of easing inflation. The price of new cars, which soared during the pandemic as automakers exploited shortages to cut promotional discounts, actually held steady in January. The cost of used cars, which rose again, rose again, but the increase was less than half of the previous month, at 1.5%, compared to 3.3%. Given that the auto sector had an outsized effect on the overall CPI, this slowdown is significant and may well continue, despite protests from Canadian truckers who have further hampered the industry’s supply chain. “We continue to expect improved microchip supply to drive sequential declines in auto prices later this year,” Goldman Sachs economists said.

In summary, the new report confirms that inflation has risen sharply over the past twelve months – a year ago the CPI rate was just 1.4% – and is now well above the Fed’s 2% target. But that doesn’t represent a clean break from what we’ve seen previously: As JW Mason, an economist at John Jay College, pointed out on Twitter, most of the rise in inflation over the past year can still be explained by a rise in automobile and energy prices. Moreover, the inflation report presents both encouraging and worrying signs.

Given these cross-currents, Powell and the Fed board need to keep their cool and avoid letting Wall Street bounce him into a panic. After its ultra-loose policies of the past two years, a tightening is certainly warranted, but it must be done wisely and with realistic expectations.

Contrary to what many people seem to believe, the Fed does not have a magic wand to bring down inflation quickly and painlessly. He can’t unclog ports, buy more semiconductors, or persuade millions of Americans who dropped out of the labor force during the pandemic to return to work. Its tools – changes in interest rates plus purchases and sales of financial assets – can directly affect credit conditions in the economy, but these changes affect prices and wages only indirectly, and gradually over a considerable period of time. What the Fed has the ability to do fairly quickly, if it gets it wrong, is crash the housing market, the stock market and the economy. Powell and his colleagues remain in an unenviable position. And the task they face has become more difficult.

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