Weekly Economic Commentary

Why is the Federal Reserve still concerned with inflation?

Chief Economist Eugenio J. Alemán discusses current economic conditions.

The U.S. rate of inflation has continued to come down, with the price index for Personal Consumption Expenditures (PCE), which is the preferred inflation rate as well as the target rate of inflation used by the Federal Reserve (Fed) to conduct monetary policy, hit 2.6% on a year earlier basis in December of 2023, down from a 40-year high of 5.5% in March of 2022. The Fed has established a target for the PCE price index of 2% over the longer run so although the PCE price index has had a 2-handle for the last several months, the Fed is still, by paraphrasing Chairman Jerome Powell, “not convinced” that the rate of inflation is guaranteed to continue to come down and hit the 2% target.

Following a question regarding the Fed’s current concerns with inflation during the press conference immediately following the Federal Open Market Committee’s (FOMC) decision in January, the Fed Chairman said that he “was not concerned with an acceleration in the rate of inflation but with inflation remaining above the Fed’s 2% target.” He also said that while goods prices were doing their part in helping bring inflation down, continuous weakness in those prices was not guaranteed. Furthermore, we assume that they needed to be sure that goods prices were not going to start increasing again while, at the same time, seeing some further weakness in services prices.

That is, the Fed continues to be concerned with services prices and particularly, we think, with housing prices. Although there are several measures of shelter costs that have come down considerably over the last year or so, the regained strength in home prices during the last 6 months or so, as measured by existing as well as new home prices, are one of the biggest threats to inflation if the economy continues to grow. Furthermore, the recent decrease in mortgage rates could put further upward pressure on home prices as it is expected that housing demand could start improving once again.

The graph below shows that although housing prices are already coming back down, they remain very high and any reversal in housing prices down the road could be a threat to achieving the 2% target, especially if goods prices also start to go up going forward. This is probably the reason why Fed officials are still concerned with inflation today.

But this is not the only reason. Lowering interest rates means that lending will increase, and thus the U.S. economy will probably grow at a higher rate, which could put further upward pressure on prices or at least not allow prices to get to the 2% target rate. Recall that there has been a lot of chatter around the idea that the Fed may be changing their target to a different rate than 2%. However, the Fed has been adamant in that the 2% target rate is their target. Thus, they will continue to conduct monetary policy to achieve the target.

This is a non-negotiable target within a central bank inflation targeting mechanism/framework because the success of this mechanism/framework depends on the market’s (firms as well as individuals) confidence that the Fed is going to conduct monetary policy in such a way as to achieve that target. Once again, as we have argued several times before, if the Fed, once after having achieved its 2% target and remained at the target for several years, decides that a different target may be more effective for conducting monetary policy, they may decide to change the target. However, today, the Fed’s existence is predicated on achieving the institution’s inflation target. And that target is 2% over a period of time.

Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those of Raymond James and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur. Last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Statistics. Currencies investing is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample.

Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.

The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100.

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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren't part of this index.

The Conference Board Leading Economic Index: Intended to forecast future economic activity, it is calculated from the values of ten key variables.

The Conference Board Coincident Economic Index: An index published by the Conference Board that provides a broad-based measurement of current economic conditions.

The Conference Board lagging Economic Index: an index published monthly by the Conference Board, used to confirm and assess the direction of the economy's movements over recent months.

The U.S. Dollar Index is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies. The Index goes up when the U.S. dollar gains "strength" when compared to other currencies.

The FHFA House Price Index (FHFA HPI®) is a comprehensive collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities that extend back to the mid-1970s.

Import Price Index: The import price index measure price changes in goods or services purchased from abroad by U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).

ISM New Orders Index: ISM New Order Index shows the number of new orders from customers of manufacturing firms reported by survey respondents compared to the previous month. ISM Employment Index: The ISM Manufacturing Employment Index is a component of the Manufacturing Purchasing Managers Index and reflects employment changes from industrial companies.

ISM Inventories Index: The ISM manufacturing index is a composite index that gives equal weighting to new orders, production, employment, supplier deliveries, and inventories.

ISM Production Index: The ISM manufacturing index or PMI measures the change in production levels across the U.S. economy from month to month.

ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers' Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.

Consumer Price Index (CPI) A consumer price index is a price index, the price of a weighted average market basket of consumer goods and services purchased by households. Changes in measured CPI track changes in prices over time.

Producer Price Index: A producer price index (PPI) is a price index that measures the average changes in prices received by domestic producers for their output.

Industrial production: Industrial production is a measure of output of the industrial sector of the economy. The industrial sector includes manufacturing, mining, and utilities. Although these sectors contribute only a small portion of gross domestic product, they are highly sensitive to interest rates and consumer demand.

The NAHB/Wells Fargo Housing Opportunity Index (HOI) for a given area is defined as the share of homes sold in that area that would have been affordable to a family earning the local median income, based on standard mortgage underwriting criteria.

The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index measures the change in the value of the U.S. residential housing market by tracking the purchase prices of single-family homes.

The S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index seeks to measures the value of residential real estate in 20 major U.S. metropolitan.

Source: FactSet, data as of 7/7/2023