Two essential questions are facing the U.S. economy right now: whether the Federal Reserve’s next change in its policy rate will be a cut or an increase, and whether the central bank’s inflation target of 2% needs to change. Give Fed Chairman Jerome Powell credit for being forthright in addressing each in a recent speech.
On the first question, he said it’s too soon to say, but left no doubt that further increases will follow if necessary. On the second, he said no: His commitment to the existing target, much in question among academic economists these days, was firm. He’s exactly right on both counts.
The Fed’s recent tightening of monetary policy, once it started, was unusually swift and severe. By most measures, it’s working. Headline consumer-price inflation has fallen from a stunning 9.1% in June 2022 to 3.2% last month — partly due to the easing of supply shocks (which the Fed can’t affect) but also thanks to much tighter financial conditions (which it can). Powell and his colleagues pay especially close attention to a measure of underlying inflation called core PCE (personal consumption expenditures excluding food and energy), which has also fallen, but by much less — from its peak of 5.4% in February last year to its current rate of 4.3%.
Taken together, the data suggests that the fight against inflation is going well, but isn’t yet won. In his address, Powell drew attention to a main component of core PCE called non-housing services — meaning industries such as health care, transportation, hotels and restaurants. These were relatively insulated from the supply shocks, hence less distorted by temporary factors. They’re also unusually labor-intensive, so more affected by higher wages in a tight labor market. In this sector, inflation has held roughly steady at more than 4% year-on-year since late 2021.
The most recent readings suggest that this measure of inflation might soon decline as well. Signs of a gently cooling labor market point the same way, while the current policy rate will continue to apply downward pressure. Even so, Powell is right that the Fed needs to see clearer results before ruling out additional tightening, let alone contemplating a lower policy rate. A soft landing is still possible, but far from guaranteed. If progress toward lower inflation stalls, a higher rate will be necessary to get down to 2%, even if that means an economic downturn.
This possibility is partly why the 2% target is being questioned. Would it really be worth a recession to cut inflation from 3% to 2%? The short answer is yes. Otherwise, when the economy next encounters such difficulties, the Fed will be asked whether it makes sense to get inflation back down to 3% from 4% … and so on. Remember that progress on inflation to this point is partly thanks to the Fed’s success in anchoring expectations. Deviating from the 2% commitment would discard one of its most powerful instruments. No one wants a recession. The resulting human costs shouldn’t be minimized. But meddling with the Fed’s target, and tarnishing its credibility, would only cause greater harm to workers and to the economy over the long term. Powell is right to say so plainly.