Mounting evidence of inflation slowdown means Fed set to ease off the brakes
Zachary Halaschak
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An accumulation of evidence that inflation is falling is raising expectations that the Federal Reserve will dial back its rate hikes next week, a prospect that bodes well for the overall economy and raises the chances that the country will evade a recession.
The overwhelming majority of investors and economists now expect the Fed to hike rates by just a quarter percentage point after its monetary policy meeting next week, a much smaller rate hike than the Fed opted for as inflation soared last year.
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The central bank can opt for smaller rate increases because of the mounting evidence that it has been successful in dragging down inflation. On Friday, the Bureau of Economic Analysis reported that inflation fell to 5% for the year ending in December, as measured by the personal consumption expenditures price index, which is the gauge favored by the Fed, down from a high of 7% in June.
Inflation is still well above the Fed’s 2% target, but Friday’s report adds to the evidence that it is trending down — that the recent deceleration is not an aberration but a sign that underlying price pressures are indeed easing.
In fact, inflation has tapered off significantly recently. In November and December, month-to-month inflation in the PCE index was just 0.1% — which equates to an annual rate well below the Fed’s target.
Other reports have similarly shown inflation falling. The consumer price index, which is more familiar to the broader public, shows that overall inflation has declined from above 9% in June to 6.5% in December; again, well above the Fed’s 2% target but a meaningful decline. The producer price index has shown corresponding declines.
Inflation expectations have also been falling. Expectations of inflation are critical for the Fed — rising expectations are a sign that monetary easing will translate into higher inflation rather than more economic activity.
Conversely, stable inflation expectations suggest that the Fed need not worry as much that the current high inflation rates will become self-reinforcing.
Consumer inflation expectations for the next year have fallen to 3.9%, according to a University of Michigan consumer survey reading on Friday. That is the lowest level since April 2021.
With all that data in hand, it appears most likely that the Fed will raise rates by just a quarter of a percentage point — much less than the 0.75 percentage point and 0.5 percentage point hikes of recent months.
As of Friday, investors are pegging the odds of a 0.25 percentage point hike at more than 98%, according to CME Group’s FedWatch tool, which calculates the probability using futures contract prices for rates in the short-term market targeted by the Fed.
Smaller rate hikes are especially good news for the housing market, which has been hammered as the Fed’s actions have translated into sharply higher mortgage rates. In general, less rate-hiking will be good for stocks and all kinds of investment, meaning brighter prospects for growth in 2023.
It’s unlikely that the Fed would opt for a bigger hike than a quarter of a percentage point. Fed Chairman Jerome Powell has worked throughout the inflation crisis to communicate the Fed’s thinking well in advance of monetary policy meetings. There is one caveat, though — the Fed has a mandatory media blackout period prior to meetings, meaning that Powell and other Fed officials haven’t been able to answer press questions for the past several days.
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A slowdown in rate hikes raises the odds that the country can emerge from this historic bout of inflation in a “soft landing” — that is, without a big increase in unemployment. So far, the labor market has remained strong. It gained 223,000 jobs in December, the Bureau of Labor Statistics reported this month — a strong performance that shows commerce is holding up despite several headwinds. The last time unemployment was this low was right before the pandemic took hold back in 2020.
Most economists, though, predict that there will be at least a mild recession this coming year.