MNI POLICY: Fed Increasingly Convinced It Defeated Inflation

Federal Reserve officials are growing confident they have nearly vanquished the post-Covid surge in inflation, laying the groundwork for a string of interest rate cuts that policymakers would prefer to be gradual but could turn more aggressive if labor market conditions deteriorate significantly.

Until recently, policymakers were trying to figure out whether a resurgence of price pressures at the start of the year was the real deal or a head fake. Improving inflation numbers over the past few months have convinced most FOMC members that the disinflationary trend is in fact intact.

The optimism comes despite the stickiness of shelter inflation, which officials seem increasingly willing to look through, in part labeling it the result of measurement complications rather than a true reflection of persistent overall inflation. There are also few worries within the FOMC that post-election fiscal policies could be inflationary, despite concerns from several former policymakers.

Rising excitement at the prospect of defeating inflation without major economic damage – the vaunted soft landing – was palpable at an unusually optimistic Jackson Hole conference in Wyoming this year. Gone were the warnings about looming economic pain from Fed Chair Jerome Powell, like from his 2022 address. Instead, he signaled optimism: "There is good reason to think that the economy will get back to 2% inflation while maintaining a strong labor market."

ON THE RIGHT PATH

Inflation is still running hotter than the Fed's 2% objective on a 12-month basis, but the latest three month of data signal prices are on a path toward that goal. By year-end, trend inflation is expected to move below 2.5%, giving the FOMC comfort to begin the cutting cycle. (See MNI INTERVIEW: Fed's Harker Ready To Start 'Methodical' Cuts)

The July CPI report, with both headline and core inflation coming in just under 0.2%, was exactly the kind of report the Fed wants to see. June's was even better -- core CPI rose a mere 0.06% in the month. July PCE inflation data is due Friday and forecasters expect a mild print, with the monthly core reading around 0.15% and bringing the three month annualized rate to around 1.8%.

Long anticipated improvements in shelter inflation have also begun to materialize, and officials may be inclined to look through a lone outlier category if the rest of the basket has fallen back in line. (See: MNI INTERVIEW: Housing Inflation To Fall Slowly-Fed's Mehrotra)

Until inflation is much closer to 2% on a sustained basis, the Fed will likely maintain a restrictive policy stance, but policymakers have room to take the fed funds rate down by 150 bps before bumping into the top of the range of FOMC estimates of its longer run neutral rate, which stood at 3.75% in June.

JOBS THE NEW FOCUS

Until recently, the hot U.S. labor market had stirred fears that wages would feed through to broader price rises. But Powell laid those worries to rest last week.

The labor market is unlikely to be a source of inflationary pressures anytime soon, he said in Jackson Hole, adding: "We do not seek or welcome further cooling in labor market conditions."

That new emphasis on employment was explicitly acknowledged in a July meeting statement that shifted policymakers' attentiveness toward the dual mandate and away from a singular focus on bringing down inflation. Under this new lens, the extent of job market deterioration has taken over as the key point of internal debate within the FOMC.

With high inflation put to bed, the Fed looks now to avoid more weakness than necessary and has entered its next phase of normalization.