The Federal Reserve’s difficult task suddenly looks even harder. The central bank’s goal has been to restrain demand enough to push inflation gently back to its 2% target without tipping the economy into a recession. Up to now, its strategy has worked well: Inflation has fallen sharply from its post-Covid peak and the economy is strong. Yet this progress lately seems to have stalled.
The challenge of the “last mile” is about to test the Fed’s determination. It’s vital that the central bank stifle any doubts about its commitment to reaching its stated goal.
Headline consumer price inflation increased from 3.2% in the year to February to 3.5% in the year to March. The so-called core consumer price index, which had been expected to fall, stayed flat — and at 3.8% remains way above target. The Fed gives greater weight to the price index for personal consumption expenditures, which is still rising at less than 3% a year. Here too, though, progress toward 2% has slowed. Later in the year, as favorable base effects roll out of the statistics, core PCE might well move higher.
As investors absorbed the new information, they dialed back their expectations of lower rates. Recently markets were pricing in 1.5 percentage points of cuts this year, starting in March. Now they expect one or two quarter-point cuts, starting in September.
November’s elections will only add to the uncertainty. The Fed insists that politics don’t influence its choices, but the need to guard its independence could complicate matters. Cuts in interest rates in September or later might be seen as a helping hand for President Joe Biden and his party — just as a decision to leave rates on hold through November (to say nothing of pushing them higher) would be criticized as aiding Donald Trump and the Republicans. Some analysts are predicting that if the Fed fails to cut rates in July, it won’t act one way or the other until after the vote.
This muddle is not of the Fed’s making, but the only remedies are clarity and consistency on its part. Throughout, Chair Jerome Powell has rightly emphasized that the central bank stands by its commitment on inflation and that it will be guided by the data. He and his colleagues should refuse to deviate on either point.
There are already calls for the Fed to tolerate higher-than-target inflation for longer, and perhaps indefinitely, now that the worst of the spike in prices is over. Heeding that advice would compromise the central bank’s credibility and could release the anchor of low expected inflation that has helped it do its job thus far.
The Fed should also stick to its guns on the data. Prices are noisy, so a month or two of surprising fluctuations shouldn’t dictate peremptory action. But persistent signs that inflation is leveling off above target mustn’t be ignored. In that case, the Fed shouldn’t rule out the possibility of pushing rates back up. Given an exceptionally tight labor market, cutting rates under such conditions would be indefensible. It’s entirely possible that the current policy rate is not as restrictive as the Fed has believed. In any event, the approaching election should have no bearing whatsoever on these choices.
There’s good news. The rise in market interest rates following the latest inflation data is a tribute to the Fed’s credibility: Investors think it means what it says. Putting that reputation at risk would be a grave mistake.
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