In recent months, the macroeconomic data has generally been consistent with the Federal Reserve successfully bringing about a soft landing: Inflation returning to the Fed’s 2 percent target without the economy entering a recession. The Bureau of Labor Statistics’ latest Employment Situation Report, released on the morning of Friday, December 8, was consistent with this trend. (The full report can be found here.)
Economists and policymakers—notably including the members of the Federal Reserve’s Federal Open Market Committee (FOMC)—typically focus on the change in total nonfarm payroll employment as recorded in the establishment, or payroll, survey. That number gives what is generally considered to be the best gauge of the current state of the labor market.
The report indicated that during November there had been a net increase of 199,000 jobs. This number was somewhat above the expected gain of 153,000 jobs Reuters news service reported from its survey of economists and just slightly above an expected gain of 190,000 jobs the Wall Street Journal reported from a separate survey of economists. The BLS revised downward by 35,000 jobs its previous estimate for September. It left its estimate for October unchanged. The following figure from the report shows the net increase in jobs each month since November 2021.
Because the BLS often substantially revises its preliminary estimates of employment from the establishment survey, it’s important not to overinterpret data for a single month or even for a few months. But general trends in the data can give useful information on changes in the state of the labor market. The estimate for November is the fourth time in the past six months that employment has increased by less than 200,000. Prior to that, employment had increased by more than 200,000 every month since January 2021.
Although the rate of job increases is slowing, it’s still above the rate at which new entrants enter the labor market, which is estimated to be roughly 90,000 people per month. The additional jobs are being filled in part by increased employment among people aged 25 to 54—so-called prime-age workers. (We discuss the employment-population ratio in Macroeconomics, Chapter 9, Section 9.1, Economics, Chapter 19, Section 9.1, and Essentials of Economics, Chapter 13, Section 13.1.) As the following figure shows, the employment-population ratio for prime-age workers remains above its level in early 2020, just before the spread of the Covid–19 pandemic in the United States.
The estimated unemployment rate, which is collected in the household survey, was down slightly from 3.9 percent to 3.7 percent. A shown in the following figure, the unemployment rate has been below 4 percent every month since February 2022.
The Employment Situation Report also presents data on wages, as measured by average hourly earnings. The growth rate of average hourly earnings, measured as the percentage change from the same month in the previous year, continued its gradual decline, as shown in the following figure. As a result, upward pressure on prices from rising labor costs is easing. (Keep in mind, though, as we note in this blog post, changes in average hourly earnings have shortcomings as a measure of changes in the costs of labor to businesses.)
Taken together, the data in the latest employment report indicate that the labor market is becoming less tight, reflecting a gradual slowing in U.S. economic growth. The data are consistent with the U.S. economy approaching a soft landing. It’s still worth bearing in mind, of course, that, as Fed Chair Jerome Powell continues to caution, there’s no certainty that inflation won’t surge again or that the U.S. economy won’t enter a recession.
The meeting room of the FOMC in the Federal Reserve building in Washington, DC.
As we’ve noted in several recent posts, the inflation rate has fallen significantly from its peak in mid-2022, as U.S. economic growth has been slowing and the labor market appears to be less tight, slowing the growth of wages. Some economists and policymakers now believe that by early 2024, inflation will approach the Fed Reserve’s 2 percent inflation target. At that point, the Fed’s Federal Open Market Committee (FOMC) is likely to turn its attention from inflation to making sure that the U.S. economy doesn’t slip into a recession.
Accordingly, both economists and financial market participants have begun to anticipate the point at which the FOMC will begin to cut its target for the federal funds rate. (One note of caution: Fed Chair Jerome Powell has made clear that the FOMC stands ready to further increase its target for the federal funds rate if the inflation rate shows signs of increasing. He made this point most recently on December 1 in a speech at Spelman College in Atlanta.) There is currently an interesting disagreement between economists and investors over when the FOMC is likely to cut interest rates and by how much. We can see the views of investors reflected in the futures market for federal funds.
Futures markets allow investors to buy and sell futures contracts on commodities–such as wheat and oil–and on financial assets. Investors can use futures contracts both to hedge against risk—such as a sudden increase in oil prices or in interest rates—and to speculate by, in effect, betting on whether the price of a commodity or financial asset is likely to rise or fall. (We discuss the mechanics of futures markets in Chapter 7, Section 7.3 of Money, Banking, and the Financial System.) The CME Group was formed from several futures markets, including the Chicago Mercantile Exchange, and allows investors to trade federal funds futures contracts. The data that result from trading on the CME indicate what investors in financial markets expect future values of the federal funds rate to be. The following chart from the CME’s FedWatch Tool shows values after trading of federal funds futures on December 5, 2023.
The probabilities in the chart reflects investors’ predictions of what the FOMC’s target for the federal funds rate will be after the committee’s meeting on March 20, 2024. This meeting is the first after which investors currently expect that the target is likely to be lowered. The target range is currently 5.25 percent to 5.50 percent. The chart indicates that investors assign a probability of 60.2 percent to the FOMC making at least a 0.25 percentage cut in the target rate at the March meeting.
Looking at the values for federal funds futures after the FOMC’s December 18, 2024 meeting, investors assign a 66.3 percent probability of the committee having reduced its target for the federal funds rate to 4.00 to 4.25 percent of lower. In other words, investors expect that during 2024, the FOMC will have cut its target for the federal funds rate by at least 1.25 percentage points.
Interesingly, according to a survey by the Financial Times, economists disagree with investors’ forecasts of the federal funds rate. According to the survey, which was conducted between December 1 and December 4, nearly two-thirds of economists believe that the FOMC won’t cut its target for the federal funds rate until July 2024 or later. Three-quarters of the economists surveyed believe that the FOMC will cut its target by 0.5 percent point or less during 2024. Fewer than 10 percent of the economists surveyed believe that during 2024 the FOMC will cut its target for the federal funds rate by 1.25 percent or more. (The Financial Times article describing the results of the survey can be found here. A subscription may be requred to read the article.)
So, at least among the economists surveyed by the Financial Times, the consensus is that the FOMC will cut its target for the federal funds rate later and by less than financial markets are indicating. What explains the discrepancy? The main explanation is that economists see inflation being persistently above the Fed’s 2 percent target for longer than do financial market participants. The economists surveyed are also more optimistic that the U.S. economy will avoid a recession in 2024. If a recession occurs, the FOMC is more likely to significantly cut its target than if the economy during 2024 experiences moderate growth in real GDP and the unemployment rate remains low.
One other indication from financial markets that investors expect that the U.S. economy is likely to slow during 2024 is given by movements in the interest rate on the 10-year U.S. Treasury note. As shown in the following figure, from August to October of this year, the interest rate on the 10-year Treasury note rose from less than 4 percent to nearly 5 percent—an unusually large change in such a short period of time. Since then, most of that increase has been reversed with the interest rate on the 10-year Treasury note having fallen below 4.2 percent in early December
The movements in the interest rate on the 10-year Treasury note typically reflect investors’ expectations of future short-term interest rates. (We discuss the relationship between short-term and long-term interests rates—which economists call the term structure of interest rates—in Money, Banking, and the Financial System, Chapter 5, Section 5.2.) The increase in the 10-year interest rate between August and October reflected investors’ expectation that short-term interest rates were likely to remain persistently high for a considerable period—perhaps several years or more. The decline in the 10-year rate from late October to early December reflects investors changing their expectations toward future short-term interest rates being lower than they had previously thought. Again, as in the data on federal funds rate futures, investors seem to be expecting either slower economic growth or slower inflation than do economists.
One other complication about the interest rate on the 10-year Treasury note should be mentioned. Some of the increase in the rate from August to October may also have represented concern among investors that large federal budget deficit would cause the Treasury to issue more Treasury notes than investors would be willing to buy without the Treasury increasing the interest rate investors would receive on the newly issued notes. This concern may have been reinforced by data showing that foreign investors, particularly in China and Japan, appeared to have slowed or stopped adding to their holdings of Treasury notes. Part of the recent decline in the interest rate on the Treasury note may reflect investors becoming less concerned about these two factors.
Federal Reserve Chair Jerome Powell (photo from bloomberg.com)
In a blog post from February of this year, we discussed three possible outcomes of the contractionary monetary policy that the Federal Reserve has been pursuing since March 2022, when the Federal Open Market Committee (FOMC) began raising its target range for the federal funds rate:
A soft landing. The Fed’s preferred outcome; inflation returns to the Fed’s target of 2 percent without the economy falling into recession.
A hard landing. Inflation returns to the Fed’s 2 percent target, but the economy falls into a recession.
No landing. At the beginning of 2023, the unemployment remained very low and inflation, as measured by the percentage change in the personal consumption expenditures (PCE) price index from the same month in the previous year, was still above 5 percent. So, some observers, particularly in Wall Street financial firms, began discussing the possibility that low unemployment and high inflation might persist indefinitely, resulting an outcome of no landing.
At the end of 2023, the economy appears to be slowing: Retail sales declined in October; real disposable personal income increased in October, but it has been trending down, as have real personal consumption expenditures; while the increase in third quarter real GDP was recently revised upward from 4.9 percent to 5.2 percent, forecasts of growth in real GDP during the fourth quarter show a marked slowing—for instance, GDPNow, compiled by the Atlanta Fed, estimates fourth quarter growth at 2.1 percent; and while employment continues to expand, average weekly hours have been slowly declining and initial claims for unemployment insurance have been increasing.
The slowing in the growth of output, income, and employment are reflected in a falling inflation rate. The following figure show the percentage change since the same month in the previous year in PCE price index, which is the measure the Fed uses to gauge whether it is hitting its 2 percent inflation target. (We discuss the reasons for the Fed preferring the PCE price index to the consumer price index (CPI) in Macroeconomics, Chapter 15, Section 15.5 and Economics, Chapter 25, Section 25.5.) The figure also shows core PCE, which excludes the prices of food and energy. Core PCE inflation typically gives a better measure of the underlying inflation rate than does PCE inflation.
PCE inflation declined from 3.4 percent in September to 3.0 percent in October. Core PCE inlation declined from 3.8 percent in September to 3.5 percent in September. Although inflation has been declining from its peak in mid-2022, both of these measures of inflation remain above the Fed’s 2 percent target.
But if we look at the 1-month inflation rate—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year—we see a much sharper decline in inflation, as the following figure shows.
The 1-month inflation rate is naturally more volatile than the 12-month inflation rate. In this case, the 1-month rate shows a sharp decline in PCE inflation from 3.8 percent in September to 0.6 percent in October. Core PCE inflation declined less sharply from 3.9 percent in September to 2.0 percent in October.
The continuing decline in inflation has caused some economists and Wall Street analysts to predict that the FOMC will not implement further increases in its target for the federal funds rate and will likely begin cutting its target by mid-2024.
On December 1 in a speech at Spelman College in Atlanta, Fed Chair Jerome Powell urged caution in assuming that the Fed has succeeded in putting inflation on a course back to its 2 percent target:
“The FOMC is strongly committed to bringing inflation down to 2 percent over time, and to keeping policy restrictive until we are confident that inflation is on a path to that objective. It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease. We are prepared to tighten policy further if it becomes appropriate to do so.”
In terms of the three policy outcomes listed at the beginning of this post, the third—no landing, with the unemployment rate remaining very low while the inflation rate remains above the Fed’s 2 percent target—now seems unlikely. The labor market appears to be weakening, which will likely result in increases in the unemployment rate. The next “Employment Report” from the Bureau of Labor Statistics, which will be released on December 8, will provide additional data on the state of the labor market.
Although we can’t entirely rule out the possibility of a no landing outcome, it seems more likely that the economy will either make a soft landing—if output and employment continue to increase, although at a slower rate, while inflation continues to decline—or a hard landing—if output and employment begin to fall as the economy enters a recession. Although a consensus seems to be building among economists, policymakers, and Wall Street analysts that a soft landing is the likeliest outcome, Powell has provided a reminder that that outcome is far from certain.
The Bureau of Labor Statistics released its latest report on consumer prices the morning of November 14. The Wall Street Journal’sheadline reflects the general reaction to the report: The inflation rate continued to decline, which made it less likely that the Fed’s Federal Open Market Committee will raise its target range for the federal funds rate again at its December meeting. The following figure shows inflation measured as the percentage change in the Consumer Price Index (CPI) from the same month in the previous year. It also shows the inflation rate measure using “core” CPI, which excludes prices for food and energy.
The inflation rate for the CPI declined from 3.7 percent in September to 3.2 percent in October. Core CPI declined from 4.1 percent in September to 4.0 percent in October. So, measured this way, inflation declined substantially when measured by the CPI including prices of all goods and services but only slightly when measured using core CPI.
The 12-month inflation rate is the one typically reported in the Wall Street Journal and elsewhere, but it has the drawback that it doesn’t always reflect accurately the current trend in prices. The following figure shows the 1-month inflation rate—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year— for CPI and core CPI. The 1-month inflation rate is naturally more volatile than the 12-month inflation rate. In this case, 1-month rate shows a sharp decline in the inflation rate for the CPI from 4.9 percent in September to 0.5 percent in October. Core inflation declined less sharply from 3.9 percent in September to 2.8 percent in October.
The release of the CPI report was treated as good news on Wall Street, with the Dow Jones Industrial Average increasing by 500 points and the interest rate on the 10-year U.S. Treasury Note declining from 4.6 percent just before the report was released to 4.4 percent immediately after. The increases in stock and bond prices (recall that the prices of bonds and the yields on the bonds move in opposite directions, so bond prices rose following release of the report) reflect the view of financial investors that if the FOMC stops increasing its target for the federal funds rate, the chance that the U.S. economy will fall into a recession is reduced.
A word of caution, however. In a speech on November 9, Fed Chair Jerome Powell noted that the FOMC may need still need to implement additional increases to its federal funds rate target:
“My colleagues and I are gratified by this progress [against inflation] but expect that the process of getting inflation sustainably down to 2 percent has a long way to go…. The Federal Open Market Committee (FOMC) is committed to achieving a stance of monetary policy that is sufficiently restrictive to bring inflation down to 2 percent over time; we are not confident that we have achieved such a stance. We know that ongoing progress toward our 2 percent goal is not assured: Inflation has given us a few head fakes. If it becomes appropriate to tighten policy further, we will not hesitate to do so.”
So, while the latest inflation report is good news, it’s still too early to know whether inflation is on a stable path to return to the Fed’s 2 percent target. (It’s worth noting that the Fed uses inflation as measured by the personal consumption expenditure (PCE) price index rather than as measured by the CPI when evaluating whether it has achieved its 2 percent target.)
Some interesting macro data were released during the past two weeks. On the key issues, the data indicate that inflation continues to run in the range of 3.0 percent to 3.5 percent, although depending on which series you focus on, you could conclude that inflation has dropped to a bit below 3 percent or that it is still in vicinity of 4 percent. On balance, output and employment data seem to be indicating that the economy may be cooling in response to the contractionary monetary policy that the Federal Open Market Committee began implementing in March 2022.
We can summarize the key data releases.
Employment, Unemployment, and Wages
On Friday morning, the Bureau of Labor Statistics (BLS) released its Employment Situation report. (The full report can be found here.) Economists and policymakers—notably including the members of the Federal Reserve’s Federal Open Market Committee (FOMC)—typically focus on the change in total nonfarm payroll employment as recorded in the establishment, or payroll, survey. That number gives what is generally considered to be the best indicator of the current state of the labor market.
The previous month’s report included a surprisingly strong net increase of 336,000 jobs during September. Economists surveyed by the Wall Street Journal last week forecast that the net increase in jobs in October would decline to 170,000. The number came in at 150,000, slightly below that estimate. In addition, the BLS revised down the initial estimates of employment growth in August and September by a 101,000 jobs. The figure below shows the net gain in jobs for each month of 2023.
Although there are substantial fluctuations, employment increases have slowed in the second half of the year. The average increase in employment from January to June was 256,667. From July to October the average increase declined to 212,000. In the household survey, the unemployment rate ticked up from 3.8 percent in September to 3.9 percent in October. The unemployment rate has now increased by 0.5 percentage points from its low of 3.4 percent in April of this year.
Finally, data in the employment report provides some evidence of a slowing in wage growth. The following figure shows wage inflation as measured by the percentage increase in average hourly earnings (AHE) from the same month in the previous year. The increase in October was 4.1 percent, continuing a generally downward trend since March 2022, although still somewhat above wage inflation during the pre-2020 period.
As the following figure shows, September growth in average hourly earnings measured as a compound annual growth rate was 2.5 percent, which—if sustained—would be consistent with a rate of price inflation in the range of the Fed’s 2 percent target. (The figure shows only the months since January 2021 to avoid obscuring the values for recent months by including the very large monthly increases and decreases during 2020.)
Job Openings and Labor Turnover Survey (JOLTS)
On November 1, the BLS released its Job Openings and Labor Turnover Survey (JOLTS) report for September 2023. (The full report can be found here.) The report indicated that the number of unfilled job openings was 9.5 million, well below the peak of 11.8 million job openings in December 2021 but—as shown in the following figure—well above prepandemic levels.
The following figure shows the ratio of the number of job opening to the number of unemployed people. The figure shows that, after peaking at 2.0 job openings per unemployed person in in March 2022, the ratio has decline to 1.5 job opening per unemployed person in September 2022. While high, that ratio was much closer to the ratio of 1.2 that prevailed during the year before the pandemic. In other words, while the labor market still appears to be strong, it has weakened somewhat in recent months.
Employment Cost Index
As we note in this blog post, the employment cost index (ECI), published quarterly by the BLS, measures the cost to employers per employee hour worked and can be a better measure than AHE of the labor costs employers face. The BLS released its most recent report on October 31. (The report can be found here.) The first figure shows the percentage change in ECI from the same quarter in the previous year. The second figure shows the compound annual growth rate of the ECI. Both measures show a general downward trend in the growth of labor costs, although compound annual rate of change shows an uptick in the third quarter of 2023. (We look at wages and salaries rather than total compensation because non-wage and salary compensation can be subject to fluctuations unrelated to underlying trends in labor costs.)
The Federal Open Market Committee’s October 31-November 1 Meeting
As was widely expected from indications in recent statements by committee members, the Federal Open Market Committee voted at its most recent meeting to hold constant its targe range for the federal funds rate at 5.25 percent to 5.50 percent. (The FOMC’s statement can be found here.)
At a press conference following the meeting, Fed Chair Jerome Powell remarks made it seem unlikely that the FOMC would raise its target for the federal funds rate at its December 14-15 meeting—the last meeting of 2023. But Powell also noted that the committee was unlikely to reduce its target for the federal funds rate in the near future (as some economists and financial jounalists had speculated): “The fact is the Committee is not thinking about rate cuts right now at all. We’re not talking about rate cuts, we’re still very focused on the first question, which is: have we achieved a stance of monetary policy that’s sufficiently restrictive to bring inflation down to 2 percent over time, sustainably?” (The transcript of Powell’s press conference can be found here.)
Investors in the bond market reacted to Powell’s press conference by pushing down the interest rate on the 10-year Treasury note, as shown in the following figure. (Note that the figure gives daily values with the gaps representing days on which the bond market was closed) The interest rate on the Treasury note reflects investors expectations of future short-term interest rates (as well as other factors). Investors interpreted Powell’s remarks as indicating that short-term rates may be somewhat lower than they had previously expected.
Real GDPand the Atlanta Fed’s Real GDPNow Estimate for the Fourth Quarter
On October 26, the Bureau of Economic Analysis (BEA) released its advance estimate of real GDP for the third quarter of 2023. (The full report can be found here.) We discussed the report in this recent blog post. Although, as we note in that post, the estimated increase in real GDP of 4.9 percent is quite strong, there are indications that real GDP may be growing significantly more slowly during the current (fourth) quarter.
The Federal Reserve Bank of Atlanta compiles a forecast of real GDP called GDPNow. The GDPNow forecast uses data that are released monthly on 13 components of GDP. This method allows economists at the Atlanta Fed to issue forecasts of real GDP well in advance of the BEA’s estimates. On November 1, the GDPNow forecast was that real GDP in the fourth quarter of 2023 would increase at a slow rate of 1.2 percent. If this preliminary estimate proves to be accurate, the growth rate of the U.S. economy will have sharply declined from the third to the fourth quarter.
Fed Chair Powell has indicated that economic growth will likely need to slow if the inflation rate is to fall back to the target rate of 2 percent. The hope, of course, is that contractionary monetary policy doesn’t cause aggregate demand growth to slow to the point that the economy slips into a recession.
Fed Chair Jerome Powell and Fed Vice-Chair Philip Jefferson this summer at the Fed conference in Jackson Hole, Wyoming. (Photo from the AP via the Washington Post.)
This morning, the Bureau of Labor Statistics (BLS) released its report on the consumer price index (CPI) for September. (The full report can be found here.) The report was consistent with other recent data showing that inflation has declined markedly from its summer 2022 highs, but appears, at least for now, to be stuck in the 3 percent to 4 percent range—well above the Fed’s 2 percent inflation target.
The report indicated that the CPI rose by 0.4 percent in September, which was down from 0.6 percent in August. Measured by the percentage change from the same month in the previous year, the inflation rate was 3.7 percent, the same as in August. Core CPI, which excludes the prices of food and energy, increased by 4.1 percent in September, down from 4.4 percent in August. The following figure shows inflation since 2015 measured by CPI and core CPI.
Reporters Gabriel Rubin and Nick Timiraos, writing in the Wall Street Journalsummarized the prevailing interpretation of this report:
“The latest inflation data highlight the risk that without a further slowdown in the economy, inflation might settle around 3%—well below the alarming rates that prompted a series of rapid Federal Reserve rate increases last year but still above the 2% inflation rate that the central bank has set as its target.”
As we discuss in this blog post, some economists and policymakers have argued that the Fed should now declare victory over the high inflation rates of 2022 and accept a 3 percent inflation rate as consistent with Congress’s mandate that the Fed achieve price stability. It seems unlikely that the Fed will follow that course, however. Fed Chair Jerome Powell ruled it out in a speech in August: “It is the Fed’s job to bring inflation down to our 2 percent goal, and we will do so.”
To achieve its goal of bringing inflation back to its 2 percent targer, it seems likely that economic growth in the United States will have to slow, thereby reducing upward pressure on wages and prices. Will this slowing require another increase in the Federal Open Market Committe’s target range for the federal funds rate, which is currently 5.25 to 5.50 percent? The following figure shows changes in the upper bound for the FOMC’s target range since 2015.
Several members of the FOMC have raised the possibility that financial markets may have already effectively achieved the same degree of policy tightening that would result from raising the target for the federal funds rate. The interest rate on the 10-year Treasury note has been steadily increasing as shown in the following figure. The 10-year Treasury note plays an important role in the financial system, influencing interest rates on mortgages and corporate bonds. In fact, the main way in which monetary policy works is for the FOMC’s increases or decreases in its target for the federal funds rate to result in increases or decreases in long-run interest rates. Higher long-run interest rates typically result in a decline in spending by consumrs on new housing and by businesses on new equipment, factories computers, and software.
Federal Reserve Bank of Dallas President Lorie Logan, who serves on the FOMC, noted in a speech that “If long-term interest rates remain elevated … there may be less need to raise the fed funds rate.” Similarly, Fed Vice-Chair Philip Jefferson stated in a speech that: “I will remain cognizant of the tightening in financial conditions through higher bond yields and will keep that in mind as I assess the future path of policy.”
The FOMC has two more meetings scheduled for 2023: One on October 31-November 1 and one on December 12-13. The following figure from the web site of the Federal Reserve Bank of Atlanta shows financial market expectations of the FOMC’s target range for the federal funds rate in December. According to this estimate, financial markets assign a 35 percent probability to the FOMC raising its target for the federal funds rate by 0.25 or more. Following the release of the CPI report, that probability declined from about 38 percent. That change reflects the general expectation that the report didn’t substantially affect the likelihood of the FOMC raising its target for the federal funds rate again by the end of the year.
A trader on the New York Stock Exchange listtening to Fed Chair Jerome Powell (from Reuters via the New York Times)
Accounting for movements in the market prices of stocks and bonds is not an exact exercise. Accounts in the Wall Street Journal and on other business web sites often attribute movements in stock and bond prices to the Fed having acted in a way that investors didn’t expect.
The decision by the Fed’s Federal Open Market Committee (FOMC) at its meeting on September 20-21, 2023 to hold its target for the federal funds rate constant at a range of 5.25 percent to 5.50 percent wasn’t a surprise. Fed Chair Jerome Powell had signaled during his press conference on July 26 following the FOMC’s previous meeting that the FOMC was likely to pause further increases in the federal funds rate target. (A transcript of Powell’s July 26 press conference can be found here.)
In advance of the September meeting, some other members of the FOMC had also signaled that the committee was unlikely to increase its target. For instance, an article in the Wall Street Journal quoted Susan Collins, president of the Federal Reserve Bank of Boston, as stating that: “The risk of inflation staying higher for longer must now be weighed against the risk that an overly restrictive stance of monetary policy will lead to a greater slowdown than is needed to restore price stability.” And in a speech in August, Raphael Bostic, president of the Federal Reserve Bank of Atlanta, explained his position on future rate increases: “Based on current dynamics in the macroeconomy, I feel policy is appropriately restrictive. I think we should be cautious and patient and let the restrictive policy continue to influence the economy, lest we risk tightening too much and inflicting unnecessary economic pain.”
Although it wasn’t a surprise that the FOMCdecided to hold its target for the federal funds rate constant, after the decision was announced, stock and bond prices declined. The following figure shows the S&P 500 index of stock prices. The index declined 2.8 percent from September 19—the day before the FOMC meeting—to September 22—two days after the meeting. (We discuss indexes of stock prices in Macroeconomics, Chapter 6, Section 6.2; Economics, Chapter 8, Section 8.2; and Essentials of Economics, Chapter 8, Section 8.2.)
We see a similar pattern in the bond market. Recall that when the price of bonds declines in the bond market, the interest rates—or yields—on the bonds increase. As the following figure shows, the interest rate on the 10-year Treasury note rose from 4.37 percent on September 19 to 4.49 percent on September 21. The 10-year Treasury note plays an important role in the financial system, influencing interest rates on mortgages and corporate bonds. So, the yield on the 10-year Treasury note increasing from 3.3 percent in the spring of 2023 to 4.5 percent following the FOMC meeting has the effect of increasing long-term interest rates throughout the U.S. economy.
What explains the movements in the prices of stocks and bonds following the September FOMC meeting? Investors seem to have been surprised by: 1) what Chair Powell had to say in his news conference following the meeting; and 2) the committee members’ Summary of Economic Projections (SEP), which was released after the meeting.
Powell’s remarks were interpreted as indicating that the FOMC was likely to increase its target for the federal funds rate at least once more in 2023 and was unlikely to cut its target before late 2024. For instance, in response to a question Powell said: “We need policy to be restrictive so that we can get inflation down to target. Okay. And we’re going to need that to remain to be the case for some time.” Investors often disagree in their interpretations of what a Fed chair says. Fed chairs don’t act unilaterally because the 12 voting members of the FOMC decide on the target for the federal funds rate. So chairs tend to speak cautiously about future policy. Still, their seemed to be a consensus among investors that Powell was indicating that Fed policy would be more restrictive (or contractionary) than had been anticipated prior to the meeting.
The FOMC releases the SEP four times per year. The most recent SEP before the September meeting was from the June meeting. The table below shows the median of the projections, or forecasts, of key economic variables made by the members of the FOMC at the June meeting. Note the second row from the bottom, which shows members’ median forecast of the federal funds rate.
The following table shows the median values of members’ forecast at the September meeting. Look again at the next to last row. The members’ forecast of the federal funds rate at the end of 2023 was unchanged. But their forecasts for the federal funds rate at the end of 2024 and 2025 were both 0.50 percent higher.
Why were members of the FOMC signaling that they expected to hold their target for the federal funds rate higher for a longer period? The other economic projections in the tables provide a clue. In September, the members expected that real GDP growth would be higher and the unemployment rate would be lower than they had expected in June. Stronger economic growth and a tighter labor market seemed likely to require them to maintain a contractionary monetary policy for a longer period if the inflation rate was to return to their 2.0 percent target. Note that the members didn’t expect that the inflation rate would return to their target until 2026.
Inflation has declined, although many consumers are skeptical. What explains consumer skepticism? First we can look at what’s happened to inflation in the period since the beginning of 2015. The figure below shows inflation measured as the percentage change in the consumer price index (CPI) from the same month in the previous year. We show both so-called headline inflation, which includes the prices of all goods and services in the index, and core inflation, which excludes energy and food prices. Because energy and food prices can be volatile, most economists believe that the core inflation provides a better indication of underlying inflation.
Both measures show inflation following a similar path. The inflation rate begins increasing rapidly in the spring of 2021, reaches a peak in the summer of 2022, and declines from there. Headline CPI peaks at 8.9 percent in June 2022 and declines to 3.7 percent in August 2023. Core inflation reaches a peak of 6.6 percent in September 2022 and declines to 4.4 percent in August 2022.
As we discuss in Macroeconomics, Chapter 15, Section 15.5 (Economics, Chapter 25, Section 25.5, and Essentials of Economics, Chapter 17, Section 17.5), the Fed’s inflation target is stated in terms of the personal consumption expenditure (PCE) price index, not the CPI. The PCE includes the prices of all the goods and services included in the consumption component of GDP. Because the PCE includes the prices of more goods and services than does the CPI, it’s a broader measure of inflation. The following figure shows inflation as measured by the PCE and by the core PCE, which excludes energy and food prices.
Inflation measured using the PCE or the core PCE shows the same pattern as inflation measured using the CPI: A sharp increase in inflation in the spring of 2021, a peak in the summer of 2022, and a decline thereafter.
Although it has yet to return to the Fed’s 2 percent target, the inflation rate has clearly fallen substantially during the past year. Yet surveys of consumers show that majorities are unconvinced that inflation has been declining. A Pew Research Center poll from June found that 65 percent of respondents believe that inflation is “a very big problem,” with another 27 percent believing that inflation is “a moderately big problem.” A Gallup poll from earlier in the year found that 67 percent of respondents thought that inflation would go up, while only 29 percent thought it would go down. Perhaps not too surprisingly, another Gallup poll found that only 4 percent of respondents had a “great deal” of confidence in Federal Reserve Chair Jerome Powell, with another 32 percent having a “fair amount” of confidence. Fifty-four percent had either “only a little” confidence in Powell or “almost none.”
There are a couple of reasons why most consumers might believe that the Fed is doing worse in its fight against inflation than the data indicate. First, few people follow the data releases as carefully as economists do. As a result, there can be a lag between developments in the economy—such as declining inflation—and when most people realize that the development has occurred.
Probably more important, though, is the fact that most people think of inflation as meaning “high prices” rather than “increasing prices.” Over the past year the U.S. economy has experienced disinflation—a decline in the inflation rate. But as long as the inflation rate is positive, the price level continues to increase. Only deflation—a declining price level—would lead to prices actually falling. And an inflation rate of 3 percent to 4 percent, although considerably lower than the rates in mid-2022, is still significantly higher than the inflation rates of 2 percent or below that prevailed during most of the time since 2008.
Although, core CPI and core PCE exclude energy and food prices, many consumers judge the state of inflation by what’s happening to gasoline prices and the price of food in supermarkets. These are products that consumers buy frequently, so they are particularly aware of their prices. The figure below shows the component of the CPI that represents the prices of food consumers buy in groceries or supermarkets and prepare at home. The price of food rose rapidly beginning in the spring of 2021. Althought increases in food prices leveled off beginning in early 2023, they were still about 24 percent higher than before the pandemic.
There is a similar story with respect to gasoline prices. Although the average price of gasoline in August 2023 at $3.84 per gallon is well below its peak of nearly $5.00 per gallon in June 2022, it is still well above average gasoline prices in the years leading up to the pandemic.
Finally, the figure below shows that while percentage increases in rent are below their peak, they are still well above the increases before and immediately after the recession of 2020. (Note that rents as included in the CPI include all rents, not just rental agreements that were entered into that month. Because many rental agreements, particularly for apartments in urban areas, are for one year or more, in any given month, rents as measured in the CPI may not accurately reflect what is currently happening in rental housing markets.)
Because consumers continue to pay prices that are much higher than the prices they were paying prior to the pandemic, many consider inflation to still be a problem. Which is to say, consumers appear to frequently equate inflation with high prices, even when the inflation rate has markedly declined and prices are increasing more slowly than they were.
A job fair in Albuquerque, New Mexico earlier this year. (Photo from Zuma Press via the Wall Street Journal.)
In his speech at the Kansas City Fed’s Jackson Hole, Wyoming symposium, Fed Chair Jerome Powell noted that: “Getting inflation back down to 2 percent is expected to require a period of below-trend economic growth as well as some softening in labor market conditions.” To this point, there isn’t much indication that the U.S. economy is experiencing slower economic growth. The Atlanta Fed’s widely followed GDPNow forecast has real GDP increasing at a rapid 5.3 percent during the third quarter of 2023.
But the labor market does appear to be softening. The most familiar measure of the state of the labor market is the unemployment rate. As the following figure shows, the unemployment rate remains very low.
But, as we noted in this earlier post, an alternative way of gauging the strength of the labor market is to look at the ratio of the number of job openings to the number of unemployed workers. The Bureau of Labor Statistics (BLS) defines a job opening as a full-time or part-time job that a firm is advertising and that will start within 30 days. The higher the ratio of job openings to unemployed workers, the more difficulty firms have in filling jobs, and the tighter the labor market is. As indicated by the earlier quote from Powell, the Fed is concerned that in a very tight labor market, wages will increase more rapidly, which will likely lead firms to increase prices. The following figure shows that in July the ratio of job openings to unemployed workers has declined from the very high level of around 2.0 that was reached in several months between March 2022 and December 2022. The July 2023 value of 1.5, though, was still well above the level of 1.2 that prevailed from mid-2018 to February 2022, just before the beginning of the Covid–19 pandemic. These data indicate that labor market conditions continue to ease, although they remain tighter than they were just before the pandemic.
The following figure shows movements in the quit rate. The BLS calculates job quit rates by dividing the number of people quitting jobs by total employment. When the labor market is tight and competition among firms for workers is high, workers are more likely to quit to take another job that may be offering higher wages. The quit rate in July 2023 had fallen to 2.3 percent of total employment from a high of 3.0 percent, reached in both November 2021 and April 2022. The quit rate was back to its value just before the pandemic. The quit rate data are consistent with easing conditions in the labor market. (The data on job openings and quits are from the BLS report Job Openings and Labor Turnover—July 2023—the JOLTS report—released on August 29. The report can be found here.)
In his Jackson Hole speech, Powell noted that: “Labor supply has improved, driven by stronger participation among workers aged 25 to 54 and by an increase in immigration back toward pre-pandemic levels.” The following figure shows the employment-population ratio for people aged 25 to to 54—so-called prime-age workers. In July 2023, 80.9 percent of people in this age group were employed, actually above the ratio of 80.5 percent just before the pandemic. This increase in labor supply is another indication that the labor market disruptions caused by the pandemic has continued to ease, allowing for an increase in labor supply.
Taken together, these data indicate that labor market conditions are easing, likely reducing upward pressure on wages, and aiding the continuing decline in the inflation rate towards the Fed’s 2 percent target. Unless the data for August show an acceleration in inflation or a tightening of labor market conditions—which is certainly possible given what appears to be a strong expansion of real GDP during the third quarter—at its September meeting the Federal Open Market Committee is likely to keep its target for the federal funds rate unchanged.
Federal Reserve Chair Jerome Powell at Jackson Hole, Wyoming, August 2023 (Photo from the Associated Press.)
Congress has given the Federal Reserve a dual mandate to achieve price stability and high employment. To reach its goal of price stability, the Fed has set an inflation target of 2 percent, with inflation being measured by the percentage change in the personal consumption expenditures (PCE) price index.
It’s reasonable to ask whether “price stability” is achieved only when the price level is constant—that is, at a zero inflation rate. In practice, Congress has given the Fed wide latitude in deciding when price stability and high employment has been achieved. The Fed didn’t announce a formal inflation target of 2 percent until 2012. But the members of the Federal Open Market Committee (FOMC) had agreed to set a 2 percent inflation target much earlier—in 1996—although they didn’t publicly announce it at the time. (The transcript of the FOMC’s July 2-3, 1996 meeting includes a discussion of the FOMC’s decision to adopt an inflation target.) Implicitly, the FOMC had been acting as if it had a 2 percent target since at least the mid–1980s.
But why did the Fed decide on an inflation target of 2 percent rather than 0 percent, 1 percent, 3 percent, or some other rate? There are three key reasons:
As we discuss in Macroeconomics, Chapter 9, Section 9.4 (Economics, Chapter 19, Section 29.4 and Essentials of Economics, Chapter 13, Section 13.4), price indexes overstate the actual inflation rate by 0.5 percentage point to 1 percentage point. So, a measured inflation of 2 percent corresponds to an actual inflation rate of 1 to 1.5 percent.
As we discuss in Macroeconomics, Chapter 15, Section 15.5 (Economics, Chapter 25, Section 25.5), the FOMC has a target for the long-run real federal funds rate. Although the target has been as high as 2 percent, in recent years it has been 0.5 percent. With an inflation target of 2 percent, the long-run nominal federal funds rate target is 2.5 percent. (The FOMC’s long-run target federall funds target can be found in the Summary of Economic Projections here.) As the Fed notes, with an inflation target of less than 2 percent “there would be less room to cut interest rates to boost employment during an economic downturn.”
An inflation target of less than 2 percent would make it more likely that during recessions, the U.S. economy might experience deflation, or a period during which the price level is falling. Deflation can be damaging if falling prices cause consumers to postpone purchases in the hope of being able to buy goods and services at lower prices in the future. The resulting decline in aggregate demand can make a recession worse. In addition, deflation increases the real interest rate associated with a given nominal interest rate, imposing costs on borrowers, particularly if the deflation is unexpected.
The following figure shows that for most of the period from late 2008 until the spring of 2021, the inflation rate as measured by the PCE was below the Fed’s 2 percent target. Beginning in the spring of 2021, inflation soared, reaching a peak of 7.0 percent in June 2022. Inflation declined over the following year, falling to 3.0 in June 2023.
On August 25, at the Fed’s annual monetary policy symposium in Jackson Hole, Wyoming, Fed Chair Jerome Powell made clear that the Fed intended to continue a restrictive monetary policy until the inflation rate had returned to 2 percent: “It is the Fed’s job to bring inflation down to our 2 percent goal, and we will do so.” (The text of Powell’s speech can be found here.) Some economists have been arguing that once the Fed had succeeded in pushing the inflation rate back to 2 percent it should, in the future, consider raising its inflation target to 3 percent. At Jackson Hole, Powell appeared to rule out this possibility: “Two percent is and will remain our inflation target.”
Why might a 3 percent inflation target be preferrable to a 2 percent inflation target? Proponents of the change point to two key advantages:
Reducing the likelihood of monetary policy being constrained by the zero lower bound. Because the federal funds rate can’t be negative, zero provides a lower bound on how much the FOMC can cut its federal funds rate target in a recession. Monetary policy was constrained by the zero lower bound during both the Great Recession of 2007–2009 and the Covid recession of 2020. Because an inflation target of 3 percent could likely be achieved with a federal funds rate that is higher than the FOMC’s current long-run target of 2.5 percent, the FOMC should have more room to cut its target during a recession.
During a recession, firms attempting to reduce costs can do so by cutting workers’ nominal wages. But, as we discuss in Macroeconomics, Chapter 13, Section 13.2 (Economics, Chapter 23, Section 23.2 and Essentials of Economics, Chapter 15, Section 15.2), most workers dislike wage cuts. Some workers will quit rather than accept a wage cut and the productivity of workers who remain may decline. As a result, firms often use a policy of freezing wages rather than cutting them. Freezing nominal wages when inflation is occurring results in cuts to real wages. The higher the inflation rate, the greater the decline in real wages and the more firms can reduce their labor costs without laying off workers.
Why would Powell rule out increasing the Fed’s target for the inflation rate? Although he didn’t spell out the reasons in his Jackson Hole speech, these are two main points usually raised by those who favor keeping the target at 2 percent:
A target rate above 2 percent would be inconsistent with the price stability component of the Fed’s dual mandate. During the years between 2008 and 2021 when the inflation rate was usually at or below 2 percent, most consumers, workers, and firms found the inflation rate to be low enough that it could be safely ignored. A rate of 3 percent, though, causes money to lose its purchasing power more quickly and makes it less likely that people will ignore it. To reduce the effects of inflation people are likely to spend resources in ways such as firms reprinting menus or price lists more frequently or labor unions negotiating for higher wages in multiyear wage contracts. The resources devoted to avoiding the negative effects of inflation represent an efficiency loss to the economy.
Raising the target for the inflation rate might undermine the Fed’s credibility in fighting inflation. One of the reasons that the Fed was able to bring down the inflation rate without causing a recession—at least through August 2023—was that the expectations of workers, firms, and investors remained firmly anchored. That is, there was a general expectation that the Fed would ultimately succeed in bringing the inflation back down to 2 percent. If expectations of inflation become unanchored, fighting inflation becomes harder because workers, firms, and investors are more likely to take actions that contribute to inflation. For instance, lenders won’t assume that inflation will be 2 percent in the future and so will require higher nominal interest rates on loans. Workers will press for higher nominal wages to protect themselves from the effects of higher inflation, thereby raising firms’ costs. Raising its inflation target to 3 percent may also cause workers, firms, and investors to question whether during a future period of high inflation the Fed will raise its target to an even higher rate. If that happens, inflation may be more persistent than it was during 2022 and 2023.
It seems unlikely that the Fed will raise its target for the inflation rate in the near future. But the Fed is scheduled to review its current monetary policy strategy in 2025. It’s possible that as part of that review, the Fed may revisit the issue of its inflation target.
HubbardOBrienEconomics.com Blog 