An Inflation Resurgence, or Just Relative Price Changes?

The Bureau of Labor Statistics (BLS) announced that inflation as measured by the Consumer Price Index (CPI) was 3.1 percent year-over-year in January. Core inflation, which excludes volatile food and energy prices, was slightly higher at 3.9 percent. The main driver was shelter. BLS’s press release notes that the shelter index rose 0.6 percent last month, “contributing over two-thirds of the monthly all items increase.” The overall inflation numbers seem to be picking up a significant relative-price effect, which is not macroeconomic but microeconomic.

If we focus on more recent price trends, the inflation picture looks more favorable. Headline inflation has averaged 2.8 percent annualized over the last three months. Core inflation has averaged 3.9 percent. In contrast, the shelter figure is 6.4 percent. Hence elevated core inflation is unsurprising: with food and energy excluded, shelter makes up 42 percent of the index. Rising shelter prices, therefore, have an even greater effect on core CPI than headline CPI.

Let’s evaluate the current stance of monetary policy using the new figures. The federal funds rate range is 5.25 to 5.50 percent. Adjusted for inflation using the headline figures, the real federal funds rate target range is 2.15 to 2.40 percent; using the core figures, it is 1.35 to 1.60 percent. 

As always, we need to compare estimates of the real federal funds rate to estimates of the natural rate of interest, which is the inflation-adjusted interest rate that balances capital supply against capital demand. When the market interest rate is higher than the natural rate, capital is “too expensive” in comparison to the economic fundamentals. Likewise, when the market rate of interest is lower than the natural rate, capital is “too cheap.” Monetary policy should help us find the Goldilocks spot, ensuring maximum sustainable employment and stable, non-accelerating inflation.

The New York Fed publishes estimates of the natural rate of interest. The range is 1.19 to 1.34 percent. That’s lower than the range of market rates even if we adjust for inflation using the larger core CPI figures. Judging by CPI-adjusted interest rates, monetary policy looks moderately tight. (It’s worth noting that monetary policy looks very tight if we adjust using PCEPI inflation figures, which puts less weight on the shelter component.)

We should also check what’s happening with the money supply. Normally, the money supply increases to match GDP and population growth. Money growth slowdowns, especially if unanticipated by markets, can throw a wrench in economic activity. Even more unusual is for the money supply to fall outright. Yet that’s what’s happening now. M2, the most commonly cited measure of the money supply, is 2.35 percent lower today than it was one year ago. Broader aggregates, which weight money-supply components by liquidity, are also falling between 0.37 and 1.42 percent per year. This is highly unusual. Many economists are forecasting a recession based on the money supply figures. The monetary contraction may not result in a recession, but it certainly reinforces the tight-money narrative derived from the interest rate data.

The Federal Open Market Committee, the Fed’s policy-making body, has indicated it will hold fast at its next meeting. It should reconsider. Given broad disinflationary trends, a modest cut is appropriate. The goal is not to make money loose, but to prevent lowered inflation from making existing policy too tight. Microeconomic relative-price dynamics increasingly drive inflation measurements. That means the Fed should not be afraid to ease off the breaks. The last thing we need in an election year is an economic downturn. The Fed is already under fire for perceptions of political meddling. Stubbornly keeping policy tight even after the macroeconomic indicators reach their desired levels will make the public more suspicious of the Fed, not less.