The CPI and the Fed’s “Single Mandate”

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Inflation: not dead yet

August CPI data were slightly strong. Overall prices rose at an annualized 2.3% on the month and 2.6% yoy, matching the consensus and consistent with the Fed's 2% PCE target. However, the core was a bit strong, rising at a 3.4% pace on the month and 3.3% yoy. The median CPI was also a bit strong, rising at a 3.2% annualized rate on the month. The good news: my favorite metric, the trimmed mean, rose at just a 2.2% annual rate on the month.

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Overall, this does not change my expectation of a 25 bp cut next week. That would be consistent with the way the Fed normally starts a cutting cycle when there is no major shock hitting the economy. It is also consistent with the idea that the Fed can not totally dismiss the risk of persistent inflation.

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Does it matter??

Many analysts have been arguing that the labor market is now the dominant driver of the Fed’s exit strategy. Indeed, Powell’s speech at Jackson Hole put a big bullseye on the labor market. He said, “The time has come for policy to adjust, the direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook and the balance of risks.”

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What incoming data?: “the cooling in labor market conditions is unmistakable. Job gains remain solid but have slowed this year. Job vacancies have fallen, and the ratio of vacancies to unemployment has returned to its pre-pandemic range. The hiring and quits rates are now below the levels that prevailed in 2018 and 2019. Nominal wage gains have moderated. All told, labor market conditions are now less tight than just before the pandemic in 2019—a year when inflation ran below 2 percent. It seems unlikely that the labor market will be a source of elevated inflationary pressures anytime soon. We do not seek or welcome further cooling in labor market conditions.”

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There was almost no discussion of other potential drivers of Fed policy. On the surface this is a bit troubling. As Adam Posen of Peterson Institute points out, the speech was too narrow and hence could be “misleading to the public.” He went on, "The labor market is first among equals in terms of determinants of inflation in the business cycle, but…there are other things," pointing to productivity growth, fiscal policy, supply shocks, and trade policy. "Acting as though these other factors don't matter, that all that matters is the labor market, I think is misleading,"

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I certainly agree. Clearly the “strength” of the labor market is important, but the trends in the labor market numbers are only one piece of the policy puzzle. Effective policy requires paying attention to the whole policy transmission process.

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First, it is important to forecast as well as track the labor market. Keep in mind that the Fed made two mistakes when it waited too long to hike in the Spring of 2021. The first is well-known: they stuck to the idea that inflation was transitory for too long. As Powell, correctly points out, however, they were far from alone in that mistake.

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The second mistake, which is less recognized, was their decision to base policy only on the realized outcomes for the labor market rather than forecasting the labor market. In late 2021 and early 2022 the Fed watched as the labor market rapidly overheated. As the chart shows it did not require a complex model to predict that the labor market was going to overshoot full employment. Forecasting means not only extrapolating trends, but paying attention to financial conditions and other drivers of economic activity. I hope and believe the Fed has learned from this experience and will be more forward looking on policy. For the labor market today, that means trying to guess whether the unemployment rate is going to rise to unacceptable levels.

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Second, it is not just the “strength” of the labor market that matters, but the strength relative to potential. That is what determines a sustainable expansion, with stable inflation. For example, if the unusually high labor force growth cools off in the coming months then maintaining strong job growth will eventually cause inflation to rebound. What the Fed should want is a “healthy” or “normal” job market, not a “strong” market.

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Third, the labor market is certainly not the only measure of economic activity that matters. The Fed needs to pay attention to the broader economy including consumer and business activity as well as overall GDP. It is not lost on the Fed that currently the most persistent inflation is not coming from the labor market, but from the housing market. It would be a huge mistake to ignore that.

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Fourth, inflation still matters. Inflation has not been slowing in a straight line. Early this year, with four strong core readings in a row, there was a good reason for the Fed to delay starting its rate cutting cycle. And it is not true that inflation has nowhere to go but down. Inflation could come back if service inflation remains sticky high and the deflation in goods prices stops. Sticky high inflation not only is a problem on its own, but impacts real interest rates and the appropriate level of the funds rate.

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All of this begs two questions: (1) how can I be confident that the Fed has not shifted to a single mandate and (2) why did Powell leave the impression that they are only focused on the labor market?

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Looking beyond this particular speech, it is obvious that the Powell and the rest of the FOMC still have a broad focus. There is an active debate about how tight or easy financial conditions are and what r-star might be. The Fed is well aware that currently most of the persistence in inflation is coming from shelter. Several FOMC members have noted that the level inflation determines the level of real interest rates and hence the tightness of policy. Etc.

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Why then the “single mandate” speech? I see three things. First, there have been big revisions to the jobs picture. Second, as Powell suggests high inflation no longer the dominant concern. Third, we need to remember that when Powell speaks he is not just addressing the financial sector, but the general public. I think the speech was designed to explain to the average Joe why the Fed was shifting. Jobs are easier to understand than GDP. The unemployment rate is a lot easier to understand than the output gap. Shifting policy in front of an election is almost certain to attract political attacks, hence clear messaging is critical. I’m actually surprised how little push back Powell has gotten for sending such a clear signal of rate cuts coming.

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The bottom line is that investors should not lose sight of the big picture. Clearly there is a strong case for cutting rates.? The size, speed and duration of cuts will depend on “all of the above.” As I will write about in more detail in my next post, I think an initial cut of 25 bp is more consistent with a normal “Fed reaction function” than a jumbo cut.