CPI Inflation and Federal Reserve Rates Decision: Back to the Drawing Board?

Chief Economist Eugenio J. Alemán discusses current economic conditions.

Before we start discussing the Consumer Price Index (CPI) again, we want to remind readers that CPI inflation is not what Federal Reserve (Fed) officials use to determine monetary policy. It is true that markets put a lot of emphasis on this measure, but we would like to caution giving too much importance to it. Please take a look at past Weekly Economics where we discuss the differences between the CPI and the PCE price indices, and the reasons why the latter is the one the Fed uses to conduct monetary policy.

With this caveat, the release of the March Consumer Price Index (CPI) was another reminder that the last stretch of the fight against inflation is not going to be easy. The fundamental reason for this is that U.S. economic growth has remained strong and job growth has kept real disposable personal income supportive of consumption and thus of continuous upward pressure on prices.

For the Fed, the biggest question is “what to do in this environment?” If it waits and keeps interest rates at 5.5%, there is a risk that economic growth continues to remain robust and inflation will probably not slow down much more, giving credence to those who have been arguing that inflation will remain above the Fed’s 2% target forever. If this is the case, and Fed officials believe that strong economic growth is the reason inflation is not coming down enough to reach the 2% target, then it has to start thinking of the possibility of increasing interest rates further. However, we believe that the Fed already knows that the fight to bring down inflation to the 2% target will be a long one and that is the reason it has the PCE price index achieving the 2% inflation target rate in 2026, not today or next year. Thus, it can sit tight and not increase interest rates and wait for the rate of inflation to, slowly, go down to 2%, which seems to be the current base case.

Consumer Price Index vs PCE Price Index