The Federal Reserve’s monetary tightening appears to be bringing down inflation without imposing undue burdens on the real economy. The Consumer Price Index (CPI) grew at an annualized rate of 2.0 percent in July. Core CPI, which excludes food and energy prices, grew at an annualized rate of 1.91 percent. This is good news: High inflation is likely behind us.
Judging by interest rates, monetary policy looks tight. The Fed’s interest rate target range is 5.25-5.50 percent. After adjusting for headline CPI inflation, the real interest rate range is 3.25 to 3.5 percent. The New York Fed estimates the natural rate of interest, which is the rate consistent with full resource utilization and non-accelerating inflation, to be somewhere between 0.58 and 1.14 percent. Hence the market price of short-term capital is significantly above the rate consistent with economic fundamentals, implying tight monetary policy.
Monetary aggregates also suggest monetary policy has been tight. M2 is down 3.5 percent year-over-year, but the rate at which it’s falling has slowed significantly. The broader measures are falling even more slowly. The Divisia measures, which weight components of the money supply based on liquidity, are down between 1.98 percent and 2.59 percent. All of them are falling more slowly, too.
Interest rates and money growth both say the Fed’s policy is appropriately restrictive. Encouragingly, the most recent inflation figures are at or slightly below the Fed’s targets. The year-over-year rates are still high, but that’s because inflation was much higher six to twelve months ago than it has been over the last six months. Annual rates are not a very reliable predictor for the upcoming year. The FOMC should strongly consider not raising its interest rate target at its next meeting.
One more feature of the inflation data merits special attention. The BLS’s press release notes the shelter component of the CPI “was by far the largest contributor to the monthly all items increase, accounting for over 90 percent of the increase.” There are two ways to interpret this.
First, it may be that inflation, which was previously broad-based, is narrowing to a small subset of markets. Supply and demand in housing markets explains what’s going on with housing prices. This is a microeconomic story, not a macroeconomic one. If so, the Fed’s job is nearly done. It can’t do anything about housing fundamentals and should not even try.
Second, it may be that estimated shelter prices lag other prices sufficiently that the Fed’s job is already done. According to the Council of Economic Advisors, “it takes roughly 12 months for changes in market rents to become fully incorporated into housing CPI.” Hence the high shelter price growth shown in the most recent report could reflect earlier price increases, which have already slowed. New economic fundamentals will show up in price data in a few months.
America’s central bank has a lot of work to do to restore its lost credibility. Nevertheless, we have reasons to be optimistic. The unemployment rate is only 3.5 percent and real GDP is up 2.56 percent from the same quarter a year ago. It looks like we’ll be able to continue whipping inflation without triggering a recession—something everyone except unreconstructed Keynesians knew was possible.