The November CPI report contained some good news on inflation. The all-items index increased by only 0.1 percent since October, and it was up 7.1 percent over November 2021. That’s below the 9.1 percent peak from June, and the annual rate has declined each month since then.
The Federal Reserve on Wednesday slowed its rate increase to 0.5 percentage points, after four consecutive increases of 0.75 percentage points. Members of the Federal Open Market Committee believe that inflation will stick around longer than they thought at their last meeting in September, saying that core inflation at the end of next year will be 3.5 percent rather than 3.1 percent.
Inflation is beginning to decline, but it’s still three-and-a-half times higher than the Fed wants it to be. Two percent is the target, and it must stay the target. (Even this would be too high; inflation would have to run below 2 percent to bring the long-term price level closer to the path it was on before.) The Fed has insisted so far that it will be. It must continue to do so, even as pressure on it will decrease as inflation falls from 40-year highs.
There are two political reasons to believe that the Fed will have an easier go of it now than it did last year. The first is that the chairmanship and vice chairmanships have been filled with Senate-confirmed appointees. That means the dynamic that former vice chairman Randal Quarles described in May — i.e., that the Fed had to wait to start potentially painful rate increases to appease politicians while Jerome Powell was being renominated — is no longer in play.
The second is that, with a Republican majority in the House of Representatives, enormous spending bills such as the American Rescue Plan Act will no longer have a chance of becoming law. That $1.9 trillion law from March 2021 likely contributed to inflation, as numerous economists on both sides of the aisle warned it would at the time. Even smaller bills such as the misnamed $400 billion Inflation Reduction Act (how far Congress has erred that such bills are now considered “smaller”) won’t see the president’s desk while the speaker’s gavel is in GOP hands.
With fewer bad fiscal policies to counteract, the Fed must stick to its monetary policy of 2 percent inflation. It cannot become complacent in the face of positive press coverage and Democratic boasts about inflation’s coming down. Coming down, yes, but not over yet.
The NGDP gap, the difference between the pre-inflation path for nominal GDP and the actual nominal GDP, was still growing for the third quarter of this year. That means monetary policy is still expansionary, and money has not tightened as much as the Fed might think despite significant interest-rate increases. Unemployment, the supposed short-run trade-off for inflation reduction, has stayed between 3.5 and 3.7 percent since March. The Fed can still take comfort in the fact that its rate hikes are not putting people out of work, and a return to stable 2 percent inflation is especially good for people living on a tight budget.
Additionally, it must beware the possibility of a second spike. In most historical cases from around the world, when the central bank loses control of inflation, there is more than one spike. The Fed seems to believe that the spike the U.S. experienced will be followed by a steady and gradual decline back to the level of inflation before the spike. That would be welcome; it would also be unusual. The Fed must be prepared for a less rosy path back to 2 percent.
A glimmer of good news is not the same as victory, and the Fed must not confuse the two. If, five years from now, inflation has settled at 3 or 3.5 percent, the Fed will have failed. It must hold the line and not be distracted by day-to-day market fluctuations or positive pieces in the financial press. The credibility of a central bank is a terrible thing to waste.