The Fed Has More Work to Do

What will the Federal Reserve do when infla- tion drops to between 4% and 5%? That’s the key question for the first half of 2023.

In 2022, the Fed tightened monetary policy faster than any time since at least 1980. It will tighten more in early 2023, but at a little slower pace than in recent months. Inflation should decline steadily because of the tightening. Also, some of the supply and demand imbalanc- es from Russia’s invasion of Ukraine, China’s Covid policy and other events are being resolved.

The Consumer Price Index’s 12-month rate of increase should fall to between 4% and 5% in the first half of 2023. At that point, will the Fed continue to tighten until inflation drops to the 2% target?

Will it stabilize monetary policy to see if inflation declines more on its own? Or will the pain and complaints from the tightening cause the Fed to ease mone- tary policy, though inflation isn’t down to its target? The markets are betting inflation will return to the Fed’s target quickly, and the U.S. central bank will begin to ease.

As I’ve said, I believe that scenario is unlikely. Inflation is likely to be sticky around the 4% level. Housing and technology are experienc- ing significant declines from tighter mon- etary policy. Manufacturing is beginning to show some effects. But the service sector is the largest part of the economy and where inflation is highest. Most of that sector is still grow- ing, though at a slower rate.

The growth is likely to continue. The balance of power continues to fa- vor workers. Small businesses report that their top problem is hiring and retaining qualified workers.

There are millions of unfilled job openings. That’s why wage growth remains near its highest rate in decades. These factors support higher household spending. High- er spending supports price increases and keeps a floor under inflation. While wage and salary increases are high compared to the last two decades, they are less than inflation. Real incomes, factoring in the ef- fects of inflation, are declining.

To keep spending, consum- ers dipped into the savings they accumulated during the pandemic and recently were saving at one of the lowest rates ever. Vanguard recently report- ed that hardship withdrawals from 401(k) plans it administers were at a record high. Balances on credit cards are increasing. These trends can last only so long. Spending will decline, but it looks like the decline will be gradual. As long as the labor market favors workers, households will spend on the goods and services they really want.

Suppliers of other goods and services will be in a recession first. Declining gas prices support more spending on other items and make a collapse in inflation less likely. Each time the optimists on Wall Street bid up stock prices and reduce interest rates they inadvertently make the Fed less likely to ease monetary policy soon.

Higher stock prices and lower interest rates increase consumers’ optimism and support more spending. That’s the wealth effect the Fed stimulated from 2009 until recently. Now, the Fed wants to reduce the wealth effect as part of its anti-infla- tion efforts. But the rallies in stocks and interest rates thwart the Fed’s efforts and force it to keep tightening.

The best scenario from here is the Fed freezes its policy in early 2023 after inflation declines. Inflation continues to decline through a mild recession or no recession. I think that’s too optimistic for the reasons outlined above. Another scenario is the Fed continues to tighten until we are in a meaningful re- cession.

The recession effects then bring inflation down to the Fed’s target in late 2023 or early 2024. The worst scenario is inflation becomes sticky around 4%. Yet, the Fed eases monetary policy because of complaints about the economic downturn. Premature easing by the Fed would usher in a new era of stagflation, similar to the 1970s experience.

I hope the optimistic scenario reflected in market prices is correct. But I believe the optimists are overlooking a number of factors. It is going to take more to reduce inflation than they believe.