Inflation and inflation expectations at year end

The outlook for Fed monetary policy in 2024 is being shaped in large part by the inflation data and by inflation expectations for consumers and businesses. The challenge facing the FOMC is correctly interpreting the inflation data while navigating the inevitable bumps in the road ahead. It is this challenge that has policymakers looking past the improvements in the all-times measures of inflation to the core – excluding food and energy – readings.

While commodities prices have fallen significantly and the mending of the supply chain has eased upward price pressures for scarce goods, prices for non-housing services remain a source of inflation. That pressure persists despite rapid increases in interest rates – the Fed funds rate is up 525 basis points since March 2022. Shelter costs also remain elevated with home values stable or increasing even with mortgage interest rates at over 20-year highs that would normally cool price increases, and increases in rental costs have yet to abate as much as anticipated.

In the end, the Fed’s preferred measure of inflation – the PCE deflator – points to consistent improvement with the November year-over-year change. Total PCE is at up 2.6 percent in November, its lowest since up 1.9 percent in February 2021. This is within reach of the Fed’s 2 percent flexible average inflation target and moving steadily in that direction. However, core PCE is up 3.2 percent from a year ago. While the lowest since up 3.2 percent in April 2021, the pace of improvement is slower and well above target. Policymakers can with reason declare inflation still too high relative to the Fed’s dual mandate for price stability and necessary to leave for current rates at their 17-year peaks for now.

Supporting the FOMC in this is inflation expectations, which have come down from the uncomfortable response to the first months of the present inflation episode. Importantly, while 1-year inflation expectations are volatile – mainly with energy costs – those for the medium term remain anchored and consistent with the Fed’s credibility as an inflation fighter. It is probable that inflation expectations will stay somewhat above the readings seen prior to the pandemic-related price disruptions. As long as inflation expectations for the medium term remain relatively stable, policymakers can have confidence that consumers and businesses do not see inflation as entrenched and that monetary policy is effective in combating it.

The FOMC’s forecasts are for rates to come down slowly and the crisis-driven low rates that characterized much of the past 15 years are not going to come back absent another major exogenous event that forces the Fed’s hand.