In some ways, central banking requires a trader’s instincts. Policymakers need to marry academic rigor with quick reflexes. There is a time for rumination and a time for action.
There was never going to be a perfect time for the Federal Reserve to start cutting policy rates from a two-decade high, but Chair Jerome Powell got a pretty fat pitch in July after a series of muted inflation reports. All he had to do was lay the groundwork with effective speeches and get his more hawkish colleagues on board. Instead, the Fed’s rate-setting committee decided to wait for a fairy tale scenario that hasn’t quite materialized. Now, they find themselves in a bind: they’re somewhat behind the curve in cutting rates as the labor market softens, and the optics of cuts have actually worsened as a presidential election nears and reported inflation minus the more volatile elements accelerates (albeit just slightly).
To be clear, the latest consumer price index is not actually bad; but it looks that way. Excluding volatile food and energy, CPI rose 0.3% from a month earlier, exceeding the median forecast in a Bloomberg survey and marking the highest month-on-month reading since April. A strange and statistically fishy jump in shelter costs drove the upside surprise — a frustratingly familiar story for inflation-watchers. Excluding food, energy and shelter, CPI rose less than 0.1% from the previous month. Headline CPI less shelter actually fell slightly and is running at a 0.5% annualized pace in the past six months!
Shelter has been a thorn in policymakers’ side for years now. The Bureau of Labor Statistics tracks costs for renters and proxies the cost of homeownership through a category called owners’ equivalent rent, which is also ultimately based on rents. While market rental inflation on new leases cooled long ago, the CPI shelter categories include rollover rents in addition to new leases, making them slower moving. They have also, frankly, proved herky-jerky, apparently susceptible to sampling error. The shelter component of CPI is simply unreliable as a short-term signal for what’s happening in the real world — an abysmal tool for near-term decision-making that the Fed must look through.
For the most part, policymakers appear to understand that, but they’re also in the communications business. They have to frame their messaging to the public around the main inflation metrics that flash across news websites and TV screens.
The upshot is that the 0.3% increase in core CPI for August will probably tie policymakers’ hands to a certain degree. Odds are extremely high that they will still follow through with a 25-basis-point rate cut in September and hint at more to come. But what they ought to be doing is cutting rates by twice as much after getting a late start to addressing the softening labor market. A separate report this month showed that nonfarm payrolls expanded by just 142,000 last month, and the trend in revisions suggests that the real number may be significantly lower. Hiring is essentially frozen in many industries, and the economy looks vulnerable to outside shocks.
A half-percentage-point rate cut may seem like an extreme measure reserved for recessions, but the starting point and destination matter as much as the pace. In this case, the Fed wouldn’t be cutting to stimulate the economy; it would be normalizing rates to stop holding back activity. At 5.25%-5.5%, no member of the Fed’s rate-setting committee believes that policy is anywhere near the “neutral” rate that would achieve that goal. The highest estimates of longer-run neutral are around 3.75%-4%.
Policymakers have a lot of ground to cover to prevent further damage to the labor market. Yet they missed an opportunity to get moving in July, and now their subservience to optics means that they probably won’t be catching up anytime soon.
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