Federal Reserve on cusp of what some thought impossible: Defeating inflation without steep recession

WASHINGTON– It was the most painful inflation Americans had experienced since 1981, when “The Dukes of Hazzard” and “The Jeffersons” topped the television charts. However, the Federal Reserve now appears to be on the verge of defeating it, and without the rising unemployment and deep recession that many economists had predicted would accompany it.

Inflation has been falling more or less steadily since peaking in June last year at 9.1%. And when the Fed’s preferred inflation gauge for November is released next week, it’s likely to show that over the past six months, annual inflation actually fell just below the Fed’s 2% target, they estimate. UBS economists.

The cost of goods (such as used cars, furniture and appliances) has fallen for six consecutive months. Compared to a year ago, prices for goods remain unchanged, kept low by improving global supply chains.

Housing and rental costs, one of the main drivers of inflation, are growing more slowly. Wage growth has also cooled, although it still outpaces inflation. Softer wage growth tends to ease pressure on restaurants, hotels and other employers to raise their prices to cover their labor costs.

“I think it’s really good to see the progress we’re making,” Chairman Jerome Powell said at a news conference Wednesday after the Federal Reserve’s latest policy meeting. “If we look at the semi-annual measurements, we see very low figures.”

On Friday, the nonpartisan Congressional Budget Office estimated that inflation will fall to 2.1% by the end of next year.

There are likely to be obstacles on the path to fully controlling inflation, officials have said. Powell insisted that “no one is declaring victory.” And he reiterated that the central bank wants to see more evidence of falling inflation before it feels confident it is sustainably returning to the 2% target.

However, many normally cautious economists are now willing to declare that inflation is almost back under control after more than two years in which it imposed hardship on millions of American households.

“It looks like inflation is back to 2%,” said Tim Duy, chief economist at SGH Macroeconomics. “It looks like the Federal Reserve has won that battle.”

Price increases are also moderating abroad, with both the Bank of England and the European Central Bank leaving their benchmark interest rates unchanged this week. Although inflation remains at 4.6% in the UK, it has fallen to 2.4% in the 20 countries that use the euro.

With inflation cooling, Powell said the 19 officials on the Federal Reserve’s policy-setting committee had discussed the prospects for rate cuts at this week’s meeting. Officials also projected that the Federal Reserve will cut its key interest rate three times next year.

That stance marked a dramatic shift from the rate-hiking campaign the Fed began in March 2022. Thereafter, the central bank raised its benchmark rate 11 times, from near zero to about 5.4 %, its highest level in 22 years, to try to slow debt, spending and inflation. The result was much higher costs for mortgages, auto loans, business loans and other forms of credit.

Powell’s suddenly more optimistic words and the Federal Reserve’s rate cut projections sent stock indexes soaring this week. Wall Street traders now forecast a roughly 80% chance that the first rate cut will come when the Federal Reserve meets in March, and forecast a total of six cuts in 2024.

On Friday, John Williams, president of the Federal Reserve Bank of New York and Powell’s top lieutenant, attempted to pour some cold water on those expectations. Speaking on CNBC, Williams said it was “premature to even think” about whether to cut rates in March. But he also mentioned that his forecast was that inflation would drop “sustainably” to 2%.

The week’s developments represented a change from just two weeks ago, when Powell had said it was “premature” to say whether the Federal Reserve had raised its key rate enough to completely defeat high inflation. On Wednesday he suggested that the Federal Reserve was almost certainly done with rate hikes.

Recent data appears to have helped change Powell’s thinking. On Wednesday, a measure of wholesale prices came in lower than economists expected. Some of those figures are used to compile the Federal Reserve’s preferred inflation gauge, which, as a result, is expected to show much lower inflation numbers next week.

Powell said some Federal Reserve officials had even updated their economic projections on Wednesday, shortly before they were released, in light of the lower-than-expected wholesale prices report.

“The speed at which inflation has fallen has been like an earthquake at the Federal Reserve,” Duy wrote in a note to clients on Wednesday.

And yet, in the meantime, the economy continues to grow, defying widespread fears from a year ago that 2023 would bring a recession, a consequence of much higher borrowing rates engineered by the Federal Reserve. A retail sales report on Thursday showed consumers increased their spending last month, likely encouraged by deeper discounts that will also reduce inflation. These trends support the growing belief that the economy will achieve a difficult “soft landing,” in which inflation will be defeated without an accompanying recession.

“We think the Fed can’t believe its luck: We’re back to ‘immaculate disinflation,’” Krishna Guha, an economic analyst at investment bank Evercore ISI, wrote in a client note.

Economists credit the Federal Reserve’s rapid rate hikes with helping to lower inflation. Additionally, a recovery in global supply chains and an increase in the number of Americans (and recent immigrants) seeking jobs have helped cool the pace of wage growth.

Jon Steinsson, an economics professor at the University of California, Berkeley, said that by aggressively raising its key interest rate in about 15 months (the fastest pace in four decades), Federal Reserve officials largely kept it in check. Americans’ inflation expectations. Expectations can become self-fulfilling: If people expect higher inflation, they often take actions, such as demanding higher wages, that can drive prices up even further.

“They played a crucial role,” Steinsson said.

Still, a continued decline in inflation is not guaranteed. A wild card is rental prices. Real-time measurements of new apartment rents show those costs rising much more slowly than they did a year ago. It takes time for that data to flow into government figures. In fact, excluding what the government calls “housing” costs (rents, home ownership costs and hotel prices), inflation rose just 1.4% last month from a year earlier.

But Kathy Bostjancic, an economist at Nationwide, said she worries that the shortage of available housing could drive up housing costs in the coming years, potentially keeping inflation high.

The Federal Reserve’s rate hikes, Bostjancic said, could actually prolong the shortage. Today’s higher mortgage rates may limit home construction while discouraging current homeowners from selling. Both trends would limit housing supply and keep prices high.

However, Federal Reserve officials appear confident in their forecasts that inflation is steadily slowing. In September, 14 of 19 Fed officials had said there were risks that inflation could rise faster than expected. This month, only eight said it.

“Their projections have mostly come down and they think the likelihood of any outbreak of inflation is lower,” said Preston Mui, senior economist at Employ America, an advocacy group.